Effects on Purchasing Power Risk on Portfolio Demand for Money

Abstract

The problem of the portfolio demand for money was first rigorously studied by Tobin [22]. It has been analyzed since then, by Hicks [8] and Arrow [1], among many others. Many interesting results and implications regarding liquidity preference and risk-taking are derived in these studies. However, the effect of purchasing power risk on liquidity preference has been overlooked in these studies. In Section II of this paper, purchasing power risk is introduced in a static model to see how liquidity preference in a real-value model might be different from that of a money-value model. We show that, in the static model, the Arrow [1] and Pratt [16] measure of local risk aversion is inadequate to describe the effect of purchasing power risk on liquidity preference. Specif ically, the structure of the covariance matrix of multivariate risk (the uncertain return on risky assets and the uncertain rate of infla? tion) is also required to study economic behavior in the presence of purchasing power risk. We then proceed to derive some analytical results based upon a quadratic utility function and to compare our results with those derived by Tobin in the absence of purchasing power risk. In Section III, the effects of purchasing power risk on indivi? dual investor's liquidity preference are analyzed within the framework of a dynamic portfolio selection model. Section IV contains a brief discussion of the implications of our analysis.