THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 594

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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 do 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 do.
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)?
9

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.