Tobin’s The Risk Aversion Theory of Liquidity Preference :

Jame’s Tobin formulated the Risk aversion theory of liquidity preference based on Portfolio Selection. According to him, an investor is faced with a problem of what proportion of his portfolio of financial assets he should keep in form of money and interest bearing bonds. This theory removes two major defects of the Keynesian theory of liquidity preference. First one, Keynes function depends on the inelasticity of expectations of future interest rates and Second one, an individuals hold either money or bonds. But according to Tobin, individuals are uncertain about future rate of interest, and an individual’s portfolio holds money and bonds rather than only one at a time. Moreover his analysis’s based on the assumption that the expected value of capital loss or gain from holding interest bearing assets is always zero. According to him, money neither brings any income nor does it imposes any risk on the individual asset holder. Bonds do yield interest so as income. It is however uncertain and involves a risk of loss or gain.

He categorised the investors into three categories. They are: 1) risk lovers who enjoy putting all their wealth into bonds to maximise risk, they accept risk of loss in exchange for the income they expect from bonds. They will either put all their wealth into bonds or will keep it in cash. The second category is plungers. They will either put all their wealth into bonds or will keep it in cash. Third category investors are risk averters. They prefer to avoid the risk of loss that is associated with holding bonds rather than money. Such investors always diversify their portfolios and hold both money and bonds. Tobin in his model, for finding out different averter’s preference between risk and expected return, has used indifference curves having positive slopes, indicating that the risk averters expect greater returns in order to bear more risk. This is illustrated in Figure.

In Figure, the vertical axis measures the expected returns while the horizontal axis measures risk OB is the budget line of the risk averter. OB line shows the various combinations of risks and expected returns on the basis of which he arranges his portfolio consisting of money and bonds. Ic and Ic’ are indifference curves. Averter is indifferent between all combinations of expected returns and risks that each point on these indifference curves represents. Combinations shown on Ic’ curve are preferred to those of Ic, but the averter will achieve equilibrium at the point’T’ where his budget line is tangent to the indifference curve Ic. In the lower portion of the diagram the vertical axis shows the wealth held by the risk averter in his portfolio and the line OR shows the risk as proportional to the share of the total portfolio held in bonds. Point E on OR line represents the portfolio mix of money and bonds that is OM (bonds) and MW(money). Hence, the risk averter diversifies his total wealth OW by putting partly in bonds and partly in cash. In any case, he has a preference for liquidity, which can only be offset by higher rates of interest. At higher rate of interest, the demand for money will be lower and the incentive to invest into more bonds will be greater. The opposite will happen in the case of lower interest rates.

Conclusion:

At the outset, Tobin considers his theory is more sophisticated theory of liquidity preference than the Keynesian theory. Because his theory starts with the assumption that the expected value of capital gain or loss from holding interest-bearing assets is always zero. Further, it is more practical oriented approach because it explains that individuals and firm diversify their portfolios and hold both money and bonds and not money or bonds. And he does not agree with the view that at very low rates of interest the demand for money is perfectly elastic. In this respect he is more practical than Keynes