The starting point of Tobin’s analysis of speculative demand for money is that, one does not find individual wealth holders, owing either nothing but money or nothing but bonds. Rather people hold diversified portfolios or a mixture of assets. The problem confronting an individual is to maximize utility firm this mixture of assets, viz., money and bonds. Holding more bonds will yield him income that would increase his wealth in the next period. However, there is a chance of capital gain or loss on bonds as there market price is subjected to fluctuations. Thus, more bonds a person has in his portfolio whose price can fluctuate, the greater is the risk of capital gain or losses. Risk reduces the utility for bonds and therefore, introduction of extra bonds in the portfolio involves trading off extra expected wealth in the next period against extra risk. The problem before the wealth holder is to get the maximum amount of utility out of his portfolio, given the rate of interest and given the riskiness attached to holding of bonds. The riskiness of bonds has an effect that is similarly, to the lower rate of interest as it increase the quantity of money demanded.
Similarly, a decrease in riskiness has an effect equivalent to that of a higher rate of interest, as both reduce the demand for money. The interest makes bonds attractive to hold and riskiness reduces the desirability of such holding. Therefore, a rise in the rate of interest and a decrease in their riskiness are the alternative ways to making bonds more attractive to hold. Thus, we can conclude that the speculative demand for money of an individual depends upon his wealth, the rate of interest (i.e., expected yield on bonds) and the degree of risk that an individual attributes to holding the bond, (i.e., expected yield on bonds) and degree of risk that an individual attributes to holding the bond, i.e., the probability of gain or loss on bonds.
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