THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 594

562 PA R T V I I Monetary Theory found for the Baumol-Tobin analysis.9 The precautionary demand for money is negatively related to interest rates Speculative Demand Keynes s analysis of the speculative demand for money was open to several serious criticisms It indicated that an individual holds only money as a store of wealth when the expected return on bonds is less than the expected return on money and holds only bonds when the expected return on bonds is greater than the expected return on money Solely in the rare instance when people have expected returns on bonds and money that are exactly equal would they hold both Keynes s analysis therefore implies that practically no one holds a diversified portfolio of bonds and money simultaneously as a store of wealth Since diversification is apparently a sensible strategy for choosing which assets to hold, the fact that it rarely occurs in Keynes s analysis is a serious shortcoming of his theory of the speculative demand for money Tobin developed a model of the speculative demand for money that attempted to avoid this criticism of Keynes s analysis.10 His basic idea was that not only people care about the expected return on one asset versus another when they decide what to hold in their portfolio, but they also care about the riskiness of the returns from each asset Specifically, Tobin assumed that most people are risk-averse that they would be willing to hold an asset with a lower expected return if it is less risky An important characteristic of money is that its return is certain; Tobin assumed it to be zero Bonds, by contrast, can have substantial fluctuations in price, and their returns can be quite risky and sometimes negative So even if the expected returns on bonds exceed the expected return on money, people might still want to hold money as a store of wealth because it has less risk associated with its return than bonds The Tobin analysis also shows that people can reduce the total amount of risk in a portfolio by diversifying, that is, by holding both bonds and money The model suggests that individuals will hold bonds and money simultaneously as stores of wealth Since this is probably a more realistic description of people s behaviour than Keynes s, Tobin s rationale for the speculative demand for money seems to rest on more solid ground Tobin s attempt to improve on Keynes s rationale for the speculative demand for money was only partly successful, however It is still not clear that the speculative demand even exists What if there are assets that have no risk like money but earn a higher return? Will there be any speculative demand for money? No, because an individual will always be better off holding such an asset rather than money The resulting portfolio will enjoy a higher expected return yet has no higher risk Do such assets exist in the Canadian economy? The answer is yes Canadian treasury bills, money market mutual fund shares, and other assets that have no default risk provide certain returns that are greater than those available on money Therefore, why would anyone want to hold money balances as a store of wealth (ignoring for the moment transactions and precautionary reasons)? These models of the precautionary demand for money also reveal that as uncertainty about the level of future transactions grows, the precautionary demand for money increases This is so because greater uncertainty means that individuals are more likely to incur transaction costs if they are not holding precautionary balances The benefit of holding such balances then increases relative to the opportunity cost of forgone interest, and so the demand for them rises 10 James Tobin, Liquidity Preference as Behavior Towards Risk, Review of Economic Students 25 (1958): 65 86