Abstract

Portfolio Analysis and the Construction of Monetary Models

This contribution aims at formulating an optimization model based on budget theory for the derivation of supply and demand functions for assets and liabilities. Since the approaches in empirical studies deviate considerably from the theoretical conception of portfolio decision-making, a budget-theory portfolio model for characterizing monetary preferences seems to be more suitable for empirical studies than the conventional portfolio model with differing expectations and variances, i.e., risks. For there is scarcely a link connecting the process of framing an expectation and the determination of expectation and variance with the demand system that is to be estimated econometrically, so that in econometric studies the difference between a theoretically well founded portfolio model and an ad hoc demand system based on holdings cannot be perceived. For the derivation of supply and demand functions for paper titles, the contribution postulates that the household’s financial preferences can be characterized by a utility function, in respect of which the arguments are the expected interest payments in the form of returns and costs implied by the claims held and liabilities incurred at the expected interest rates. Using the appropriate indirect utility function, with the interest and financial assets as arguments, an integrable demand system for paper titles is derived, which is compatible with the maximization hypothesis and conforms to the Yale principles of monetary model construction. Since this system gives optimal stocks, an adjustment mechanism can be specified to explain the deviation of the observed data from the optimal stocks. With quarterly data for the Federal Republic of Germany for the period from 1968-1975, a supply system with five assets and a demand system with four liabilities are estimated for the private non-banking sector.