Quick summary: Liquidity Preference as Behaviour Towards Risk by James Tobin (1958)

The basic idea of the paper is to explain the liquidity preference for money by individuals. It tries

to lend more generality to the Keynesian liquidity preference theory by relaxing certain

assumptions and thus makes the theory more empirically sound. The author uses the analytical

tools of utility theory (indifference curve analysis) and probability theory to explain how an

individual makes a choice between cash and bonds, depending on his expectations about future

interest rate and the capital gain/loss associated with it.

Demand for money basically constitutes demand for transaction balances, investment balances

and speculative balances, central question being, why should investment balances be held in

cash, in preference to other monetary assets? Monetary assets are obligations to pay stated cash

amounts at future dates with no risk of default. They are like cash, subject to changes in real

value due to fluctuations in price level. They are marketable, fixed in money value with no risk

of default. The other category of investment assets includes corporate assets, real estate, etc.,

which are not the subject of discussion of liquidity theory. It is primarily concerned with

allocation of wealth among cash and alternative monetary assets. There are two reasons for

holding investment balances in cash: inelasticity of expectations of future rates of interest;

uncertainty about the future of interest rates. The demand for cash balances is derived first on the

assumption of fixed expectation of future rate of interest and then the assumption is relaxed to

take account of uncertain expectations of future rate of interest

The advantage of the alternative theory offered by Tobin is that it doesn't depend on inelasticity

of expectations of future roi, but can proceed from the assumption that the expected value of

capital gain or loss from holding interest-bearing assets is always zero. Further it can explain

diversification unlike Keynesian theory which assumes that investor holds only one asset.