On inflation and money demand in a portfolio model with shopping costs

In this paper, we investigate the conditions under which expected inflation might influence the money demand, using a microeconomic model where the transactions of the representative agent are facilitated by its holdings of money. We assume that the agent holds a real asset, along with a range of nominal assets, that may include domestic money, foreign money, domestic bonds and foreign bonds. In this model, the optimal choice between money and bonds is embedded in a portfolio choice between the real asset and risky assets (the Merton problem). We show that, as long as the agent is not constrained in her holdings of bonds, the demand for domestic money will not, in general, depend on expected inflation. The demand for money may however become a positive function of the inflation rate in case the agent is constrained in her holdings of foreign bonds. The only case in which the demand for domestic money may depend negatively on the inflation rate is when the agent faces a binding constraint in her holdings of domestic bonds.