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Tobins The Risk Aversion Theory of Liquidity Preference :

James 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 individuals
portfolio holds money and bonds rather than only one at a
time. Moreover his analysiss 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 averters 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 pointT 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