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Lecture 4. The Micro-foundations of the Demand for Money. Keynes’ Demand for Money Sound micro-foundations on the demand for money based on risk and return Extension of risk-return analysis to a multi-asset framework. The Keynesian Demand for Money.
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Lecture 4 The Micro-foundations of the Demand for Money
Keynes’ Demand for Money • Sound micro-foundations on the demand for money based on risk and return • Extension of risk-return analysis to a multi-asset framework
The Keynesian Demand for Money • Demand for money = demand for active balances + demand for idle balances • The Motives approach - 3 motives • 1) Transactions • 2) Precautionary • 3) Speculative
Regressive Expectations • Agent’s expectations of interest rate adjustment depended on their subjective evaluation of the ‘normal’ rate of interest. • The normal rate varies between individuals • If the normal rate is above the current rate, the interest rate is expected to rise • If the normal rate is below the current rate, the interest rate is expected to fall
Expectations of capital gain or loss • So • g > 0 if r > re • g < 0 if r < re • But this evaluation is for one agent only and will differ for different agents
R R* Idle balances MT M Total
R Md M
The breakdown in liquidity preference • The special case is when all expectations merge between agents • If all agents have the same expectation then the speculative demand for money breaks down
Criticism • No portfolio diversification - all or nothing model • Psychological basis for the expectation of the rate of interest is not explained - inelastic expectations • Only a short-run argument. If the rate of interest is constant for any length of time, then agents would revise their normal rate.
Tobin Model • Assumptions • .Agents choose between two assets, Money (M) with zero yield and bonds (consols) (V) with known coupon B per period. • .No borrowing • .No transactions costs • .Each agent has a quadratic utility function in return R • .Wealth W = M + V
Tobin continued • Let = share of money in wealth, let = share of bonds in wealth and g = capital gain • Return on the portfolio is R
Tobin preliminaries • W=M+V; = M/W and = V/W • + = 1 • Capital gain = g • R = (r + g) 0< <1 • g = E(g) = 0 g ~ N(0, 2g) • R = E(R) = E[(r+g)] = r
- + 0
R P’ P 0 R = 1
Risk averter - plunger R U1 U0 R
Risk averter - diversifier R U1 U0 R
Risk lover R U1 U0 R
Risk lover - always at maximum risk position R U1 U0 R
Plunger - all or nothing R U1 U0 R
Diversifier R U1 U0 R
Quadratic utility function • U = aR + bR2 a > 0, b < 0 • It can be shown that all that is relevant to the agents choice is the first and second moments of the distribution of returns • dU/dR = a + 2bR > 0 (positive marginal utility) • d2U/dR2 = 2b < 0 (risk aversion)
Conclusion • While Keynes is based on ad-hoc theories of psychology, Tobin’s theory is based on explicit optimising behaviour • Wealth effect may outweigh substitution effect • Analysis based on first 2 moments only • Assumes cash is riskless
More ? • Money is dominated by income certain riskless assets • Better at explaining the diversified portfolio between income certain bonds and risky bonds • Capital risk may not be the motivation for holding safe assets • Not robust to state of nature
Multi - asset application • The model can be extended to dealing with money and a composite bundle of risky assets • 2 stage process • Stage 1 - identify the combination of assets that is superior in risk and return - efficient set • Stage 2 - allocate wealth between money and composite
U0 C A B 0