Day 218 portfolio allocation decision

portfolio allocation decision

As we know, there are three major motivations for people to hold money: transaction requirement, precautionary requirement and speculative motive. Therefore every individual need to make decisions about distributing their funds to matching current and future objectives.

When an individual develops the portfolio allocation decision, he/she determined the individual demand of money. However, there is an opportunity cost of holding money on hand, the nominal interest rate determines that returns can be gained by investing the money into financial assets. According to the cost-benefit principle, people will choose to hold money only if the benefit exceeds the cost. In this case, the benefit for holding money is affected by the real income which increases the incentive to consume, and the price level due to more money is required to settle transactions for higher price. Therefore, individuals will choose to maintain more money on hand when the nominal interest is low, or the price and real income are high. On the other hand, the supply of money is determined by the reserve bank’s open-market operations, so the curve is vertical since its not affected by the nominal rate. Like other demand-supply curves, the interception indicates the equilibrium level in the money market. In order to explain the process of reserve bank adjusting nominal interest rate, it is critical to comprehend the bond price identification factors The essential part is, when the nominal interest is high, the bond price drops. That is because the buyer will rather to invest on other financial assets if the nominal rate is higher than the coupon rate. So the price of the bond needs to be lower to compensate the opportunity cost for buyers. Therefore, when the money market is at disequilibrium, individuals are not happy with the proportion to their wealth held as money, then they will purchase/sale bonds. These actions will increase/decrease the price of bonds, so the nominal interest rate will decrease/increase in the contrary of bonds price. The variation in nominal interest rate will affect people’s behavior to hold money until the equilibrium is reached. The borrowers and lenders in financial markets are considered rational. Hence if the reserve bank lowers the cash rate in the overnight market, it is reasonable the suppler of the bonds will seek to borrow at that market for the lower rate. In addition, the lender in the overnight cash market will become the demander in the bond's market, pursuing the higher rate of return. 

As a result, the demand of bonds will increase and the supply of bonds will decline. The rise in bond price will lead the reduction in nominal interest rate. Consequently, the aim of the reserve bank, which is to reduce the overall nominal rate is achieved. That is how central banks influence the demand of money by adjusting nominal interest rate. Although the reserve cannot control the supply of money and targeting an interest rate at the same time, the monetary policy enables it to adjust real interest rate in the short-run, since the inflation is slow to adjust. Because the higher interest rate will encourage saving and therefore, reduce spending, the reserve bank can reduce interest to stimulate aggregate expenditure. The contractionary gap can be eliminated as well as the expansionary gap.