Testing the Portfolio Theory of Money Demand in the United States

The portfolio model of asset allocations is used to estimate the demand function for real M2 in the United States. The explanatory variables include real return on real M2, real returns on stocks and bonds, wealth, and the expected inflation rate. The cointegration test shows that the demand for real M2 and the explanatory variables have a long-term stable relationship. According to results of testing for proper functional forms, we can reject the logarithmic form but cannot reject the linear form. The empirical results also show that the demand for real M2 is positively associated with the own interest rate and wealth, and is negatively affected by the return on stocks, the return on long bonds, and the expected inflation rate. However, the elasticity of real M2 demand with respect to the return on stocks is quite small. Wealth has the largest elasticity. The return on bonds and the expected inflation rate are important macroeconomic variables for the government to monitor due to their relatively sensitive relationship with the demand for real M2.