Model SIM in the previous chapter considered household wealth, at the period-end, as a single line-item; in other words, households did not have any choice to make with regard to how they chose to save/hold un-consumed disposable income. Model Portfolio Choice (Model PC) recognises that households can make choices as to how they hold their wealth. In this model, the choices available are Money (Liquidity) and Treasury Bills. This model differs from the SIM model in recognising this choice and is expanded to consider the factors determining the choice and the implications (for wealth, GDP, Government, etc) of the choice made.
The theory underlying this model is that the choice which the household makes as to how much wealth it chooses to put into T-Bills is a two-step decision. In the first step, the household pre-determines how much of (net) income it will save. (The remainder is disposed of, or consumed). The second step is the decision as to how much of the savings will be allocated to interest-bearing Bills. As (in this model)there are only two assets to which residual wealth can be allocated, the decision as to how much is left in Money is derived from this decision (Wealth = Money + Bills; => Money = Wealth - Bills). The latter decision is the Portfolio Choice decision.
In arriving at the allocation decision (how much of wealth to allocate to each of Money & Bills), there are two predominant theories argued. One is that the proportion of wealth allocated to Money (& to Bills) is linked to the flow of money (income); and the other, that the proportion is related to total wealth.
The theories are not necessarily at conflict. The share of wealth which households allocate to Money is found to be negatively related to the interest rate. The share is also positively related to disposabel income, because of the "transactions demand" for Money to which this gives rise.
The rate of interest is fixed for the period because the rate payable on a Bill is determined at issue of the bill, and for the purposes of the model the period of the Bill to maturity is always assumed to equal the period itself. Therefore the rate of the bill is fixed for the period, and this rate is a policy-decision rate. The Government decides on the monetary policy needs of the economy, and sets a rate (r = mean-r) accordingly. If this rate was allowed to fluctuate during a period then the model would not hold for the period and in effect each period of differing rate would in effect be a different period for modelling purposes.
If r was not fixed for the period, changes in r would result in changes in the value of notes held by the household. This would cause a further variable of capital gains arising upon each interest rate change. Therefore for the purposes of simplifying the model, for the period, interest rates are held fixed to avoid this additional factor and so avoid complicating the model.
Question 2
1) Liquidity-preference is a potentiality or functional tendency, which fixes the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity-preference, we have M = L(r)
The three divisions of liquidity-preference defined as depending on
(i) the transactions-motive
(ii) the precautionary-motive
(iii) the speculative-motive
The propensity to consume decides how much of your Money will be spend and how much will be reserved (saved). Schedule of the amounts of resources valued in terms of money or wage units which individuals will wish to retain in the form of money.
If the interest rates decrease an increase in the quantity of money should occur, (Keynes) but that is not always true, If liquidity preference of the public is increasing faster than the increase in the quantity of money.
2) PC model encompasses Keynes 3 ideas of the liquidity preference.
Precautionary motive
Transactions motive
Speculative motive
The PC model distinguishes between disposable income and consumption. This idea is also inherent in Keynes wirttings.
PC decision has 2 steps
Savings are decided on
How the savings will be allocated
In both models the rate of interest is the equilibrium in the desire to hold wealth in cash form an the availability of cash.
In the pc model the quantity of money held depends on the rates of interest that can be obtained on other assets.
