What is Portfolio Balance Approach to Demand for Money?

Based on Keynes’ liquidity preference theory, Baumol and Tobin have developed an alternative approach to transactions demand for money called “Portfolio Balance Approach” in which the portfolio behaviour of individuals and institutions has been stressed in the process of monetary management.

In this approach, the demand for money is viewed as a joint demand for all liquid assets. Holding of money is preferred by the people because it enables them to maintain cash disbursements and carry on transactions when there is lack of synchronisation between timings or receipts of income and payments.

The holding of cash balances, however, involves costs which can be measured in terms of the rate of interest forgone by not holding other forms of income yielding liquid assets.

Keynes had taken a single interest rate for measuring the opportunity cost of idle cash balances. Baumol and Tobin, however, considered an entire range of interest rate differentials for measuring the cost of holding total cash balances.

In the asset portfolio, different types of assets have different digress of cost, liquidity, money value certainty income certainty and real value certainty.

Cash balances have little cost of acquisition. But, holding of cash does not yield any income. Further cash has money value certainty but is unstable in real value, i.e., its purchasing power. Cash is the most liquid asset.

On the other hand, bonds and other long-term securities have no easy liquidity but they are income yielding assets and their real value is more certain.

For balancing the different degrees of different characteristics of these different assets, the portfolio assets will be so maintained by prudent people that funds will be distributed in such proportions of the given assets that their marginal yields become equal.

Thus the choice between money and near-money asset is primarily decided on the basis of the average of return and the relative variance in certainty of income yields.

James Tobin states that the optimal inventory holdings of cash balances are determined by many related factors, such as:

(i) Rate of returns on alternative liquid assets available;

(ii) Cost of exchanging assets;

(iii) Volume of non-financial transactions;

(iv) Transaction and delivery costs which are to be balanced against interest and carrying costs;

(v) Pattern or risk aversion or minimisation in combination with different assets in the portfolio.

Baumol asserts that firms and individuals would usually keep the value of their income in certain money balances for the exchange utility function and the rest in the form of income-yielding assets.

The following formula is suggested by him for measuring the transaction demand for money holding:

Md/p = √2bT/i

Where,

Md/p = demand for cash balance in real terms.

T = volume of transactions.

i = the rate of interest.

b = brokerage fee and/or all other charges meant for borrowing or convening a bond or other assets into cash.

It shows that the demand for money is stable, and negatively related to the rate of interest. David Laidler’s empirical tests based on the U.S. data confirm this.