TRANSACTIONS DEMAND PRECAUTIONARY DEMAND SPECULATIVE DEMAND Medium of exchange ; held for transactions Bridges gap between receipt of income and eventual expenditure Depends positively on level of income Negative relation with rate of interest Important for business sector Keynes believed that apart from the money held for the planned transactions additional money balance were held in case of unexpected expenditures such as medical or repair bills. Varies positively with income and negatively with interest rate Why an individual would hold any money above that needed for the transactions and precautionary motives when bonds pay interest and money does not ? This is because of the uncertainty about the future interest rates. If interest rates were to move in such a way that the expected capital loss of bonds outweighs the interest earnings on the bonds, investors would want to hold money instead. Interest rate is the opportunity cost of holding money. If interest rate is less i.e. the opportunity cost of holding money is less, you will want to hold the money in hand. Bought a bond at then prevailing market price of : $1000 Entitles you to payment of : $50 / year (coupon payment) Market interest rate is $50/ $1000 = 0.05 (5%) If interest rate remains same i.e. 5%, you will still sell the bond for $1000 If interest rate rises to 10%, going price today for a bond with a coupon payment of $50 would be $50/0.10= $500. You paid $1000 for a bond but now you will be selling it at a capital loss of $500. A rise in market interest rates results in a capital loss on previously existing bonds. If interest rate falls to 2%, going price today for a bond with a coupon payment of $50 would be $50/0.02 = $2500. Decline in interest rate, results in a capital gain on previously existing bonds. ASSUMPTION : investors have a preconceived view of the normal interest rate. Keyness theory can be criticized on two grounds: 1.) Keyness theory implies that investors would hold all of their wealth in bonds as long as interest rates was above the critical rate. {a rate below which the expected capital loss on bonds outweighs the interest earnings on bonds} If interest rates fell below this critical rate, investors will transfer all their wealth to money. Keyness theory can not explain why an individual investor holds both money balances and bonds as store of wealth, but such portfolios does occur. 2.) According to Keyness theory, investors hold money as an asset when interest rate is low because they expect interest rate to rise and return to normal level. A crucial element of Keyness theory is the existence of a fixed or at least only slowly changing normal level for the interest rates around which actual interest rates fluctuates. Keynesian economists have made some modifications that take into consideration the portfolio diversification which doesnt depend on Keyness particular assumption about investor expectations of a return of the interest rate to a normal level. According to Tobins theory, the individual investor has no normal level to which the interest rates are always expected to return. The best expectation of the return on bonds is simply their interest rate (r). Money in contrast is a safe asset. Tobin argues that an individual will hold some proportion of wealth in money because doing so lowers the overall riskiness of the portfolio below what it would be if all the wealth was held in bonds. Determination of the Optimal Portfolio The upper quadrant shows the individuals optimal portfolio allocation. At point E, the risk-expected return trade off in the market reflected by the slope of line T, is just equal to the terms on which the investor is willing to accept the increased risk in return for an increase in expected return, given by the slope of the indifference curve U2. The lower quadrant shows the bond and money holdings(B*, M*) that correspond to this choice of risk and expected return. MONEY DEMAND AND RATE OF INTEREST Relationship b/w interest rate and asset demand for money Tobins theory implies, as did keynes, that demand for money as a store of wealth depends negatively on the interest rate Within tobins framework, an increase in i can be considered an increase in payment received for undertaking risk. When this payment is increased, the individual investor is willing to put a greater proportion of the portfolio into the risky asset (bond) and thus smaller proportion in safe asset (money)