Page 131 - DECO402_Macro Economics

Macroeconomic Theory

Notes (iv) Boumol’s Inventory Theoretical Approach is better than Classical and Keynesian both the
approaches because it integrates transaction demand of money in Capital Theory on keeping
in the mind of assets and those interest and non-interest cost.

Self Assessment

Multiple Choice Questions:
3. The interest-costs and non-interest costs in keeping remaining cash, remains—
(a) Included (b) Remaining
(c) Maximum (d) Minimum
4. If brokerage increases then the amount of withdrawals become........................
(a) more (b) less
(c) mos (d) none of These.
5. As income increases, ……...………….. also increases.
(a) transaction demand of money (b) income
(c) expenses (d) none of These.
6. If income increases four times, then optimal transaction remaining becomes—
(a) Only three times (b) Only double
(c) Only equal (d) Only four times.

14.2 Tobin’s Portfolio Selection Model: The Risk Aversion Theory of
Liquidity Preference

James Tobin presented The Risk Aversion Theory of Preference based on portfolio selection in his
famous text titled as “Liquidity Preference as Behavior towards Risk”. This theory has removed two
main weaknesses of Keynesian Theory of Liquidity preference. One, Keynesian Theory of Liquidity
preference depends on the flexibility of expectations of future interest rates; and second, person keeps
either money or bond. Tobin has removed these weaknesses. His theory does not depend on the
flexibility of expectations of future interest rates, but starts with this consideration that the expected
value of capital profit or loss is always zero on keeping the interest holder assets. Again, it is also clear
that there is money and bonds both in the portfolio of any person; it is not that only one in a time.
On presenting his portfolio selection model of liquidity preference Tobin starts on considering that
there is money and bonds both in the portfolio of any assets holder person. He has no income and
risk from money. However, interests and incomes both are gained in bonds. However, the income
gained from bonds is uncertain because the capital gain or losses are also included. However, the
investment in bonds will be greater, the risk of capital loss from those will also as greater. Investor
can only bear this risk when the gaining incomes from bonds fulfill it.
If expected capital gain or loss is g, then it is consideration that investor will work on the base on own
estimation of probability distribution of it (g) and it is also consideration that the expected value of this
probability distribution is zero and is independent from the level of interest rate r started on bonds.
There is M portion of money and B portion of bonds in his portfolio, where the total of M and B is
One. No value is negative. The function of portfolio R is:
R = B (r + g) where 0 ≤ B ≤ 1
Because g is a random variable of which expected value is zero. So the function of portfolio is:

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