Futures and Money Demand : A Portfolio Allocation Model

The modern theory on money demand incorporates the evolution of financial markets behaviour, and then of households' allocation and preferences in different fashions; innovation in money demand can be considered as an increasing number of liquid assets between which to choose, considering money as a store of value and as a mean of payment; innovation modifies the utility of money holdings, through wealth and substitution effects. Liquidity has to be weighted with risk aversion and profitability to incorporate portfolio innovation properly. Aim of this paper is to look at the effects of futures' introduction into the demand for money function, expressed accepting the Keynesian-Tobin approach, where substitution effect is present. Then, a model of portfolio utility is going to be developed and discussed. The model is based on the Lancaster type utility function, and utility depends on profitability and liquidity, the first being related to risk too. Futures are (more) liquid assets and exhibit the same risk of the underlying, so that the efficient portfolio should include futures instead of the underlying; derivatives crowd out underlying assets and this effect influences money demand parameters. The interest rate elasticity (sign and magnitude) is analysed and discussed as the parameter incorporating the innovation. Some empirical verification confirms the model coherence and meanings for the US economy