( .

,, µ,;,,oY
."'~ •un~ (L cur', •cs) a1c <lc,ived by ilddmg th,c L, curves
,,,..,:y' pCtlntC levels, and 1hc Li_ cuc, -c hon,.ontalh· The
r----------------, 141 ·,.\

d .• d ' II •
~ ; lf', ,pdie.tl~ 1he lllOllC~ . Cll,l.lt\iw,C ,or tl _the three 1110lJ\•es
,! .-,111 I

,<I'" 1 " iou!-. p,c1;:1ut1ou.:tf) and spcculatwc) as II function

· , !J".ll 1 >' of ,n1e n:s1. Tiu: posu ,,,n or the L cun,c.1 dq,c:nds
J ttt: •~ ~",cl of ,.11~0111c: :m mcrcasc in mcome (fron, y
10
·'9- \he: · il, the L cun·c to lhc nght (frOIU L(Yi) 10 L{Y) 1and
., ll s)Ul• y . ' ' l
11 1~ ,n u'ICOmc <fro m 2 to Y \) ,,,ushin the: L curve
10
1d~ (Cioni Lt Yi) \O L(Y 1H T he sh.ape; or the L curve JJ
~' ~ __ , bl· 1hc i,, curve.
Jf""''""v •
p0RTFO LIO BALANCE
,., 1
~r
• ,-.PPROACH C
1~, oc:u,.-.,: i: oF .. c- ·v::
8AL Af.1 CES IL,!
Cp
Keynes' l1q111dl1y theory u n~ ~rdy b1forcated aJ.tgrt,;atc-
~ 1d for money m10 tmnsucuons dcuuind and spcculaovc
,...,d
Tt~ 1rnus:,cuon demrmd depends u pon the lc,·d or i.ncomc
Jlld~tYl•es .,,uu111cd :a const..,111 relation between moncy~holdin,g
)lld 1ncomc . The spcculnt,vc .dcm:1nd 1s b~ on ponfolio
d ~ b wtuc.b co1is1dc~s: the )lcl~s or as.\cts mu! compete \\i11t
)' ,ot&J iu the andwidunl s pon.foho Keynes limits his an.11ys
15
C

"
C
iot" 'O :uscu . 1nan~y i'lnd bonds ·n,c combin:uion or dcm,,ri.d
lfll)t.lvcs w11h two d ifferent ilpproaches is lncont1S1cnt.
Jn tho J)OSl•Kcyncsuln pcnoc:t, two U1'1J0r m1c11,pts l.:a,·c 0
- .,
O E\lMo'O FO =I OtE
bco m,ldc to correct 1his 1nconsis1cn<.-y. tu) W1ll1.an1•B.numul 5MA~C£"; (l ;!
.alld Jame1 Tobin •~pplu.:d Ille ponfolto armly,.,s 1u lhc u:msact1ot'-'
dem»l(l, a nd th) Milton Fncdman ;mcmp1cd to bh1, 1hc s.hnrp
dl$11ric1Jon bctw1.!cn mot1vc-.s o( ho lding moncr bal:mc-c,.
cs11phlsLSmg that money 1.s held ro, ni.any pu11,osci and 1h.:n
lko:1and ro,
n10nc::,.· ts sensilh·c to vunouy ccouonu;;- v:irbblcs
11.lun•ol's Analysis
B:wmul 1 m :ai.11taini th;at trnn ,i.tictinnJ demand for m11n1:-}
11bo i:lqu.-n 1h un the r;11e of inten:-.it4 In ract, hohlin,: uf u.1ih
ii,-.t,n 1n·o l) l te31 of cosb :
(<1) lnttrc,t c...,St\: - When <:-'.ash balances :uc held. w1: fora;o
m1eccst♦1ncumc b) 1101 holding mhc.r forms o f 11\.lcrc.st•) 1clding
IIUCU 0 ·o•AL OEMANCI
1C ) ;:o o1 MONEV t l l
{It) Non-inh::rC:!11 Co~L\ - When bon..is an: converted 1n1u Ag.<A,8&C.
cash. ccn.mn <:O!i.l,; like brdu:r.:igc rec. po.~1:1gc c h.iri.--es, etc, nee-rue.
Baumol dc,·eloped his algcbric model or lhc ~m:111d for tra1lStli.:t1!,)11 b.alanc:c~ ,U the 1111cro tc~ t i He
;mumes tha1 tm mdl\idu:1ls imi:su h is monC)• 1ncome m 1011:1'C.'tt-bi!'.1nng bonds o mJ thc~i.: hon(ls t1re oomcncd
for moni:,· in cqlW.I lots of nrnount M each \O fuuncc Ms c."\'.pc.nd1tur~ 1t 15 :.1tso assu11)Ctl 1ha1 the rndn1dual
lias uniform c,'<pc;uditurc& o r uausuctiou.s •~ mu.kc o,,c r t1 gi,cn 11111c pcnod. Each co u,c:rs,011 " 11\ involve a
brok...-rngc foe T he total brokc:r:,ge r~ will be 1..-qu:al to the nwubc:r or .:01\\ crsiom, into money trn-.cs ltlt
1, W.J B.lumcl 9 19$2); ·Th• TransaeUons Demand !o, Ca,,;h An ln-1.nw,y TheotiiiUC APPfMOh .. Ou.lrte"fly .JO~.rn..i/
o/ E'co.nom,cs- Vol 66. No. 4 (Nov , 195a) pP S4S--56
-- , J S·A •110 ns.
Mo net11,1 c,
~~e-
~I. the :unoun1 of ibond_s .;on, crll::d 10
14

t• T rcprc~nl.S tol.11 tr.ins.K ~

t,wkcr:1~, f.x. <'ft, cT :'>fl ,, ,,re •
a11d b. ihc brol crJfC fee cJ int<> ruoOC'. she srldf\ 1du.1l (or~ mtcrcst•1~omc Ud lie~
E,,f' 11rrn: " h::n t,.-:id> Jr, , on~c~111rc nod .; cq u.11 IU the a, cr.igc mo~ holdmg pa corn~
c1-1nconic fN):O!lC \)\ ,I ,ix- npcnd pcltLII IS 101.111ntcrPt 111<.0tnC forgone \\Ill be I f \ t -:? 1 Hect
snlcodr r\ t ' I mul11phcJ ~ 1hc ,ntcrol r ·•," ti) ndllu~ period I CJ "'ill bl: "'rittc n a t
pen · • h tul tn:'1:$ O'Cf I ie c,pc
10 1.11 co<1 of hc>td,n~ :.1, • • 1 ~-1 ,
;. - . , - fl
C \I I :
-- • ;is~u tcd \\Ith 11100C' hold mi; " h1cl1 cu1 be o::-ac ~
L. c~or is rn min1n11..c t he .-•~ • I ,._ •
The
J1m o f ,.,..- 111 ' the rcuh cqu.il tu u;ro .m<l so \Ing t ..c cqu.111on
d1iTcrcntWlllf C \\ llh IC>ll''-1 h) :'> I. sc,u ni:
,lC _!._ ~ . 11 t;
.t'1 ' ._,:
,, r
or '
--._,. ti'

·- 11,T
,,'
--
or \I i

\I " \
~"l ,s,
ill I

holdl.agskr
Thus. cqu.111on (5) 1s the: d.:nund for mol\C'I Cun.:tion "h1.:h 1111phcs tlut the oomtrul mo~
the .:ost-rn1mnU51!lg mdl\ 1du;ils \\Ill ,~ d11'--ctl~ "'th the sqwrc rOO( of pl.mn.cd nomm.al c.'\-pc.ndnun:s a:
1m-crsch ""h the squJrc root of nurl.ct sntcre>t rJtc: Thu dcnund fun.., 100 CJII be e., presscd m tams <i Ital
monC\ balJn-.-"\.-S l~l'P). b~ making c,-pcnd11urc:s :inJ the brol crJgc fee real nugrutudes. 1 e . ~ dlnd1J!! ~
nonun:il nugrutudc b~ J su11.1bk pncc md~-..
B.aumor • mot.Id >°11!!):CMS .a num~r of cunclu~oru :
(1) The d.:nund for real cash \x1l3llC<.'S 1\l P1\,111 rue b~ less tlun the re..11 mc-0mc cor real c~--r:s
1mph111g that thac are econonucs of sealc m holdmg 1nont\ b.1l.\nct.S ThtS furthoe: unplles !bl!
mcomt" ,cloc11~ should nsc o,cr 11rnc \\llh real mco111e
(11) Th~ ckm:md for real bJl:inccs 1s 10, arunt "1th rcspc.:1 10 clungcs in the pncc IC\~I l!ld. tins.
1nfu1ton C-Jln affect the d,nund for morn.: on!~ b~ alt>!nng the r.itc of mtcrest
(111) The p<l\\Cr of th,: monclJJ"\ poh0 ha~ b..-cn grc:11!~ ,m:n":lscd \\ "tth .in 1n.:rcasc m mo~ SllpP'
the model 1mpltcs th;Jl for J gl\ en 1111crcst r.1tc. nomuwl 111,:01111: mus t n s.c: tr. the sqll.lf'( o{ 11!\
increase m non1111al bJl.inces before cquthbnu m can be resto red •
(w) ~r.msacuons demand has been form:ill~ rccogms.,.-d ,111h the Sp(\."1llall, c: dcm;:md SO\, . 3 n Ulm'~
~~:::_ccidmg \I hcilicr to hold 11 calLh m motK'Y or bond fom, . must consider ti~ rn;u\.c1 I'll~~
111
 (iv) T;,ms.1c1ion~ demand has been formally r~gl\1 SCO Wllbo"'d ro;..;,1 must consider the mark.Ct rate of
when dccid1ng whether to hold we.11th tn money or n ·
interest.
Tobin's Analysis
th
Keynes· liquidity preference analysis requires an investor to put all his weall h ~ er in cas; or i~ some
r:~;t~~ng~~d~~~~~~~. ;~~~~ :~ ia0::\~·1:a~h~ :!i~~P!:':~~~t~r;~~1: ; ;1an~i~~~~it~o~:t:
~ ~~cl in which the simultaneous desire to avert risk and to maximise the ut1hty from wealth W111 lead an
mdiv1dual to choose a di\'ersificd portfolio consisting of both money and bonds.
Tobin introduced the concept of risk a\'ersion. The basic idea of risk av~rsion is that given two assets
~'1th san_1e ,wera~e re.tum. an investor prcre.rs that asset which has less dis~rs1on or standard deviation. The
Y~~:d of n sk avers.ion 1s explai ned by two 1hmgs : (a) There is always the n sk that an asset with an unstable
the would .Pr~v.1dc. a smalle.r aver~~e return, if 11 has to be sold before maturity. (b) lnco~e being. subject to
I
woul~w~f dumnislnng marginal ullh~.' the g~i ns of utility to the wealth-holder during pcnods of higher yield
smaller titan the loss of utility dunng periods of low yield

t. t~a.~~
5 1 1
19~~~- !-;8~ ~~quidity Preference as Behaviour Towards Risk'' Review of Economic Studies, Vol. 25
 fl • J.11., or

i,
1J
, ,, • - I

a,
ECfrti..111011 ~"' ) , l1u1 ~nd 1t.1 la 1h,1J 1
tlic, a\C r.111"1:' of
lflJl rdQl'll dlepc11i!~ Ul'JO'H 11-e rnU.'l of lfffc:~ t ;lnd He
n' ciJ ~.1p~M ..i.,mn :and kkna on the l11/\i~ rncnll 1n 1

Jt.,1141 fC'bl I\ '1 n1oocl ~ s r~phtt;aJl\r Illu11tnd ,n

•I ftjlifC '
!ll f;lrdtr to fi oo 001 d1t dn UilOA ol ,._,CJllih mn,tu
j
,, ~!'It\ liCI~ hond• lei l}S mmlilt l h--11 1rutwlly. UC' tDUI
l!lfo}Uh of :,in mJJ\ td'1u~ . l'f' ~Id onl~· ll-1 1noJ1q tcn111,
1
IJ Ct)IJ~ to Mu l tl llJ 111,i.11 .\DU me u\;J I If ,~ IIOJ:di AU
hb ~th m 1l1c fom1 of OOillLi.. U\K'I npxu:i.11 v.alw:i at
:Iii) wcllh Ill lhe end or lhc Jwldm, pc-ncdl \\ould ht
~li ( I ~ r o I wbctc 1bc unccc.,r ruii 11 lff, .llld i~ rlik
jS\~\~I UI t•o l'he,1 I he mi [JC j@II\IUijl l1i-lo JJi\d: lg C'Al'I be
1

•ldcitd ,I ll, 1lit bud~.c• c-OQ5trru nr hl'C'

1

lb: lt1dmtfmRCC cun a , dcs11rn11~ .!IJ I . 11, 11

, dope deq11,ward 1m~ t-0 ehc ldl , Uk!J~m, 1b.11
(•) u,, ~ lbc u'ldn idu.ii kl bc.u" noort rWJ. 1~
«~l'!d vtlilie of his, ..eil•II mu.11 mncrc..uc. And
!liil be(J1111C lni;JGl.i~ m \~tilth , 1cJds di rn 1mdu111
lllihi, . cvcr•l111.i cr l ll(fftllM:~ m e~ rr:d \\~Jl•h 1u t
nctu~ 10 mduot hm1 ~Jif 11dd'ni.::1111t'l 11n1f()rrn
~,i:n~l.U fl( d.J.. A tui,t!1t1 Lrddkrtni..: Cll f\C' 11111hC11cs
brl(Cr llnto1U1t of rrw.{IC'i.: 1td ·\\.~ JI h \\i'imh lhc l!;lltic ~ d
of ru.k E,,C'f) ..-.C'al1h-hf1IJ.n mc.1 u, r hoo.sc tliuim
c011ibm,,t10n, of 1no.nc) rmd bon.ch tl111t co.1bln lun1to 0
1'Qtl1 c'l\tc h-R]Jq51 dCCC5Slblc nlf11frc~nct CYf\\:
1

Fig. I .
h11ill.1~~ 'when int'ertst I:\ r~ 1ll11: tqmh~rimn b ..,__ _ __ _ _ _ _ _ _ _ _ _ _ _ _ _--■,1
1
•

pwtn bv ~ - w~ 1hc b11cl~• coMErnml ~lne 1-1 lilllgtnl to i1x!Jlfc~ CJUnt: Ii U 1he rali or •ntCH::Jt falh, to
'H, bt!I nsl ctu11p1mc nl ~mnim.'ii mM.:hJn~cJ t~~o). 11h1M1 the ~ · 'budget 00tmrunt Ii nc 111-;atll be ~ 11 1111d 'lhc
-.itlb-ltor:de.r will he mn IXJUII 1tirmm •• r E I on rt3'e [0\.'1,1:r 1nd'I rfr:1rul(( a.n1:1 f I The l'lt'Wi eqm libr1un1 f'O\lb')n I E l 1
n 1a lbe ldl m 1hc ~ni' Ulf.~I potil10n ~ E'Q)1\\ tuch Ind~la ctiJ1 1hc ~1l1b•bot'Ckr bcmn teu nsk ed tllcrdorc
ftiitdl more mo11C1)' .u,J 1~,li bonds \lo,•t'!r"\'Cf. E1 ,n.i,· b:- ta 1hc n,ght or·E.J o r ffl.l) be juu btl~· E1 ~
upon lbe "l'IY 1h~ \\.CJlth.~ holder ~,~ighLI mk n 00mp.1rcd to tttotn cmpLriQUy
bll lbon. Tobin conchtdes tlliU en~ ru ,he m.11tc1 mti or 1111ttmi fUCI.. ihci 11'1d1n:dwull u ""111m1 to bcu
nk'!re nu. ~ hohilu1o; mon:: hcrwb 11"" I~-t1KNK)', ~rid lb ~Lr lht ~~ of n*
ma. (or lhc liQflc ffllel'al 1m t.
~t.r bond.~ :md ,mue: mol\C) w.n, M ~ Id in 'llx< 1ndlvidUi12·,. portfolio
l

\
~i,,Mon•r 1s1,.\

~11J e:rpi1.,I g:un due IQl ll c.,pcc.·ud fall m t.ho 1n;ukct 1nu:rdl r;Jtr: or )Q-t 11ny :uihcipalcd c.1p11.11I lt>sS
4!)0P:a•c ,.,1...,u.-d me 1n 1hc nmrkc1 r.uc
,.fl•• ~
equllY, The cqutty " 1d<:1111cal •• 1hc bond c""l)l 11,11 11 con1•1n1 a-· ol•l"·••s cscal>IDf ,. 111.tt
5, ,c .;ueau, .ah1t11)S 1ni1h11.:u1u conu:ml purch:1~111~ !10\lU The ) 1cld on equity fr,) h a:mpolC:d or thttt
'4 111"1~ ( iiJ ib t fl'JJ)OII yJrlt/, (h) 11ny c ~lcd c.aplu,1 gium or IM~t J ut 16 c-hang:s in 1nttrut raaei. And
.iet':ill)'
"'~C,(r~- ....-red chlln~cs 111 1h, 8"'""~ puce IC'\tl
,<J' & conrmodllles. l'hy~c•I go01h held by " cal1h-ow11Cfl y1<ld 11,u;rnc: in t111d (1 t uulny) ~tkh Clll1llOI
•u-cd tw an c;(phcll 1n1crc1t r.arc. However. Lhcu 1e1l r~wn is :Jfeaed by llw: chang~ m 1ht pncc IC\·t l.
f~: 11
usci 1hc nom111.11I yield on comrncd111c.5 frr) 10 comia of thcu a:pccted r11c of puce dl.llngt pa uru1

••••; Hurn•• Capital. In 1hc: :>bst11<:e or ,1,,,ry. 11t1 man.e1 price lor human copillll c:ru,, and thus• 11k
l(li~P 011 1luh fonu or wc.11lt11 coinn.ol ht computed dircetl)
• e. Other Variables. Fricdrn>n 1111100111cc, a ,·,u·lllblc rksrgnarocl by u 10 11>rwl lor any mnucncc other
(IJIJ ,~0111~ rh1u c1111 be cxpcc1cd to 11JTCC"t 13!'11C5 i1nd p,efrrcnccs for money,
fflld"""'s Oenwtd-for•Honey Function
The c1cn1a11d fonC11on for 1110nt)'. :u (onmulatcd hy Pricd1t1Jn, gi,,:n below
M • /( Y. • . P. , ., ,,, ,,. , ) .(IJ
Wll..'1'C. M • :aggrc~1c dct11J1wj for mont)
Y -=- toual now or income
w • n,uo o( non-lmman 10 hlimt.111 \\'Clllh
p s general price 11.,·cl
fb • bond )'Lclds.. lhc niartct bond intc:rcsl rJlC
' *-=- cquily )'lt lds. the nl.'lrkct 1n1rrcst nuc of cqu1t11:s,
,, -= the expected r:1tc of ch.'lllt"t or pna;s of commocbbd
u • uulity dc:tcrmm«s \'tU:iJ1blCJ wluch lend 10 mf1ucnct t."IJICI 11nd prcfcrcncu.
TIit deow1d runc11on for money in Equat,011 (11" Independent or 1hc nomLII unm, Ulld 10< rncasunng
_ . mnablts. It indic:ua ~'" !he •rno,1111 of money clcrn:1nd<d ch>n~,.. propomoo,udy 10 !he changts 1n
1k 1~ u in winch pnc.cs and mooey income 3rc t.,presscd T11c: equ.1uon thus expresses the first dcg,rct
1or110gencous fur1t1ion ol P and Y Or, in oti1<r nords, ii price level and mono)' increases 10 A rimc:s !ho!
on~11.1I 1"'~'- dcm:rnd ro, money allll ma= 10, times ill origillAI qU4lltl!y Thus, 11~ can write,
i.M • /f).'rf, ·w. AP. ' tt. r,,. ,,, u) ...(2)

H. l =-/;. ll1<11 ~ • / ( ; . •.i.,,.r,. u) .(l)

Equauon t3) r<prcscnt< demand lor 1110IIC)' ,s • dem•nd lor n:al bolilllOCS, wtilch is • runcnon of real
TariJblcs, mctcpcndtnt o( moneuuy values. According to fri cdm:tn, money is a lu.xury like durable comumcr
pu, With a ch:mbic in per c~1p1ta mcomc. people's sumdard or living chan~"CS and. as rcsul&, lhcy may desire
to txild casl1 bal;mccs more or less acc.01dmg 10 the change in the per capita uamc Bu, t.hc income to which
Q!h b:U:tl'IC(S arc 1,dJus1cd i.'i pcrnmncnt mro1~)C ruthcr thJ.n cuncn1 income.

flled1111n and KeynH Compartd

Fricdm~n'!i tboorl'tkal dem11nd runditon dirrtn rrom that dt'·doptd b)' ~nH ia ,un,•
ways :
(1l Kc,·nt'$ di1tinguishcd between three rnoll\'CS for holding money balances, '·" lranSXlion molt\'C,
prec:iu11onary motk't and speculatm: motiYe (or bdwce:n acti\'c and idJt b.tlanccs). f flC'dm:an
m..-U:cs oo dis1tnc1ion lW;twee11 tltc motJ\'CS for holding money b.lbnccs. For him, moAC\' ts hc,!d
boca1ase 11 is :l 1c111pornl)' :tbooc ror gcncrnli.scd purchasing power which provides \'3rious $:niecs
lo its posscsso1. mcluding as a producti'l't r~or.
(11) Fricdru,m , ruplO)S a bro:ider ddlnl!1011 ol money than thal tL<Cd by K.ci11cs. While Friedman defines
money 10 include :iii assct.S that SCJVI! as :i temporary i bodc for gcncnb.scd purch.1.sing po"cr. lhc