The theory of asset demand also stresses the function of money as the store of value. This theory elaborates on why individuals demand one asset or typical portfolio of assets over the other alternatives.
What is an Asset?
Asset is a valuable resource that an individual or company owns. It has economic value and works as a store of value.
“An asset is a piece of property that is the store of value”.
Example of assets includes money, stock, bond, buildings, houses, factories, cars, and so on. There are many ways people categorize assets based on underlying characteristics and features of assets. These characteristics and features may be the duration, tangibility, requirements, and so on. Therefore, the categories of assets may be any of the financial and nonfinancial assets, current and fixed assets, tangible and intangible assets, necessity and luxury assets, and likely others.
Why People Demand One Asset Over Other Assets?
Most probably, the answer is provided by the determinants of asset demand. There are many versions of the theory of asset demand. However, the crux of all of these theories is more or less the same in that there are four basic determinants of asset demand.
Wealth is the total resources, including all assets, owned by the owner. The wealthier the individuals, the more resources they possess to buy more assets. Therefore, an increase in wealth leads to a rise in demand for assets.
The expected return of an asset relative to alternative assets, over the next period, is another key determinant of the demand for the asset. Precisely, the rise in an expected return of assets relative to alternative assets leads to an increase in demand for that asset.
Risk is the degree of uncertainty associated with the return of a typical asset. The higher the risk of an asset, the lower will be the demand for that asset.
Liquidity is the ease and speed with which one asset is converted into cash. The higher the liquidity of one asset, the more will be it’s demand.
When Theory of Asset Demand is Portfolio Theory of Money Demand?
This is when money, as an asset, is demanded. This is why, the portfolio theory of money demand is also called a theory of asset demand. The portfolio theory of money demand is a special case of the theory of asset demand. This is because money is the focal asset under demand consideration. The portfolio approach to money demand accepts money as the store of value and elaborates why money is demanded over other alternative assets in the portfolio.
The portfolio theory of money demand states that people will hold money as part of a portfolio of assets. The amount of money people will demand depends on return and risk on money relative to the risk and return on other alternative assets.
In the figure above, there are 4 determinants of asset demand; all the determinants, but risk, are positively related to the demand for assets as shown by respective arrows. Likewise, the lower portion of the figure shows the relationships between other determinants of money demand and demand for money.
Other Determinants of Money Demand
As in the Keynesian theory of money demand, demand for real cash balance is positively related to real income and negatively related to nominal interest rate in the portfolio theory of money demand. This is true primarily because of two reasons: First, income and wealth move together; when income is high, there will be high wealth to support a high demand for money. Second, the expected rate of return on money (equivalently the opportunity cost of holding money) will be high when the interest rate is high, so the demand for real money balance declines.
Now, let’s point out the other determinants of money demand as follows:
There is a positive relationship between income and demand for money. The higher the income level, the higher will be the demand for money.
There is a negative relationship between interest rates and money demand. A higher rate of interest implies a higher opportunity cost of holding money, and, hence, the demand for money declines.
There is a negative relationship between the advancement of payment technology and money demand because people need less money to settle the transaction.
Risk of Other Assets
Money demand and the risk of other assets are positively related. When the risk of other assets increases, money becomes relatively less risky compared to other assets, so the demand for money increases.
Investors don’t like to hold money when they perceive inflation risk, because money becomes relatively more risky. Instead, they prefer inflation hedges, assets whose real returns are less suffered to inflation, to holding money. When they hold Inflation hedges, their real returns are less affected than that of money when inflation rises.
Thus, there is a negative relationship between inflation risk and demand for money.
Liquidity of Other Assets
Currency and checkable deposits are sometimes called dominated assets because investors generally get higher returns on other assets and still feel as safe as money. Moreover, even when the liquidity of other assets rises, money becomes relatively less liquid, so the demand for money falls.
Therefore, the liquidity of other assets and the demand for money are negatively related.
According to the theory of asset demand, the four basic determinants of assets are wealth, expected return, risk, and liquidity. Moreover, the portfolio theory of money demand states that people hold money along with other assets in a portfolio. In line with Keynesian theory of money demand, portfolio theory insists on the function of money as a store of value.
Besides, there are also other determinants of money, a dominant asset. They are income, interest rate, payment technology, risk of other assets, inflation risk, and liquidity of other assets.