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

A)

Intuitively, every investor will perform a mix of capital plus bonds based upon his or her prospect. An investor would require to build a collection such that he or she makes a nice profit but additionally risk is captured. That indicates he or she will pick a strong mix of money including bonds. In distinction, money is a reliable asset because it allows no return at all. At the equivalent time money is a safe asset considering no capital gain/loss is made by holding.If the bond yield drops but the riskiness continues the same, the market for bonds is forced to fall. This suggests as risk rises, people will want minor risk and the requirement for bonds will befall.If alone bonds are included, profits would be highest no doubt though the risk to which the investor is endangered will also be highest. He argues that wealth as an asset is enjoined as an objection to risk.

B)

Tobin's model describes the equivalence among holding money moreover risky assets also state that the percentage rate defines this stability plus vice versa.The supposed return on the collection is the interest that can be received on bonds. The larger the risk, the larger the return expected. As expected return raises money holding drops.During this case when the central bank purchases bonds by positive yields, it grows the money supply moreover decreases the yields. As the yield goes underneath, people will own more wealth. While people own more extra money, the yield will rise again furthermore the business will be in balance repeatedly.