Modern Quantity Theory of Money predicts that the demand for money should depend not only on the risk and return offered by money but also on the various assets which the households can hold instead of money.
The money demand should depend on the total wealth, the reason being wealth measures the size of the portfolio to be allocated among money and the alternative assets.
Thus, Money demand function is essentially a function of wealth (W):
Two alternative forms in which wealth can be held are:
(ii) Equity (Shares).
... (M/P)d = L (rs, rb, ne, W) …(1)
Where rs is the expected real return on stock rb is the expected real return on bonds
IT’ is the expected rate of inflation
W is real wealth.
M → nominal money demand
P → Price level
Equation (1) shows that Demand for money depends on return on bonds and equity. Inflation affects the amount of wealth held.
Therefore, Md depends on return on bonds and equity. Inflation affects the amount of wealth held.
If rs or rb increases, money demand reduces, because other assets become more attractive.
If FT increases, money demand reduces because money becomes less attractive.
If W increases money demand increases because higher wealth means a larger portfolio.
For simplicity, equation 1 can be written as:
(M/P)d = L(Y, i) …(2)
Real income (Y) is used instead of W
i is the interest rate. It is the return variable which includes nominal interest rate.
= rb + Πe
This demand function of money equation (2) is very similar to that derived from the Keynesian approach.
Limitation of the Portfolio theories:
The utility of portfolio theory in studying the demand for money depends on which measure of money supply is used.
The portfolio theories of money demand are plausible only if we adopt a broad measure of money supply (M2):
This is because:
M1 is the Narrow Measure of money as it includes only coins and currency with people and demand deposits which earn very low or no interest rate.
M1 = Currency + Demand Deposits
Thus portfolio theories are useful only when we take (M2) measure of money supply because:
M2 = M1 + Saving accounts + money market mutual funds.