Tobin’s Portfolio Balance Theory

Keynes approach to the demand for money suggested that individuals should, at any given time, hold all their liquid assets either in money or in bonds, but not some of each. This is not true in reality. 
Tobin’s model of liquidity preference does away with this problem by explaining that if the return on bonds is uncertain, that is, bonds are risky, then the investor worrying about both risk and return is likely to do best by holding both bonds and money. 

Portfolio balance approaches emphasize the role of money as a store of value. According to these approaches, people hold money as part of their portfolio of assets.  Portfolio approaches consider money offers a safe return, whereas the prices of stocks and bonds may rise or fall. Thus Tobin has suggested that households choose to hold money as part of their optimal portfolio. 

• The demand for money depends on the risk and return associated with money holding as also on various other assets households can hold instead of money. 
• The demand for money should depend on real wealth, as wealth measures the size of the portfolio  allocated among money and the alternative assets. 
• There is a trade- off between risk and return. The individual attempts to achieve a balance between assets that involve high risks and high returns and those, which involve low returns and little or no risk.  
• The marginal utility of wealth starts to decrease as wealth increases. An individual who receives an income once in a time period a part of which he puts aside as savings. Assume that the assets available to him are only money and bonds. 
• The price level is assumed to be constant. In holding money there is no return or risk. 
• Bonds yield an interest, affected by the price fluctuations and yield an uncertain income.  
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This income has two components: 

• The interest which accrues on the bond and whose amount are  certain. 
• The capital gains and losses, the probability of which will have to be assessed by the individual such that the expected value of the gains and losses are balanced

The expected yield from holding bond matches with the market rate of interest. Tobin considered the demand for money as a store of wealth. He focused on an individual’s portfolio allocation between money holding and bond holding, subject to wealth constraint.