Question

Now consider Tobin’s model of the speculative demand for money. Risk-averse investors can hold money or long-term bonds. Money is a safe asset, but offers a zero return. Long-term bonds have a positive expected return, but are risky assets.

A) Explain intuitively how investors determine the shares of long-term bonds and money in their portfolios. For a given level of riskiness of long- term bonds, what happens to bond demand if the bond yield falls?

B) Assume that the central bank implements quantitative easing by buying long-term bonds with a positive yield rather than zero-yielding short- term bonds. According to Tobin’s model, what must happen to long-term bond yields for the bond market to be in equilibrium? Explain.

Answer 1