Title Chapter 7 Monetary transmission mechanism (1).docx ✅

2 of the different assets depends on wealth holders’ views of the degree of substitutability and complementary of the assets. As a monetary transmission mechanism, portfolio balance theory gives both preference of wealth holders and characteristics of assets, apart from their yields. Money is one of the best assets among many that may features in the portfolio of wealth holders. Other includes wide range of financial assets such as government bills and bonds, debentures, equities, real assets, and so on. (Real assets means durable and non-durable consumer goods) Each assets provides a yield the nature of wealth depends on the characteristics of assets. Yields on assets will reflect not only money yield but also the speed up assets converted into the money and their capital value of certainty, risk etc. The yield obtain from each assets are subject to diminishing returns. Greater the quantity of assets. The smaller will be the yield from additional unit of assets. The portfolio will be balance when the marginal yields are the same on all assets. The demand for any assets will vary directly with its own yields and inversely with yield on all other assets. Thus, the demand for money as a proportion of total portfolio will rise when the yields on other assets falls and fall when the yield on other assets rises. A change in yields of any one assets will affect the demand to hold other assets. How much the demand for any assets is affected by a change in yield on other, depends on how close they are substitute for each other. Link of portfolio balance and goal variable The portfolio balance transmission mechanism operates through aggregate expenditure. Adjustment to portfolio leads to increase expenditure and through that prices, output and employment. In order to link the portfolio balance and goal variable we can consider following assumptions in simple Keynesian approach; 1) Economy consists of two sectors i.e. household sector and business sector. 2) There are three kinds of assets i.e. money, real assets and government bonds. 3) There is only one financial rate of interest on bonds. 4) The demand for money and real assets are taken into perfectly inelastic in order to yields. If the monetary policy undertaken through open market operation which rise money supply, than bond prices will be goes up and the rate of interest on bond goes down. This reduces opportunity cost of investing on real capital assets, rises the size of optimum capital stock which leads to increase in demand for capital assets and flow of investment expenditure. This channel of monetary influence is called cost of capital channel.