Money, transactions and portfolio choice

Real money balances are held separately forconsumptionandportfolioreasons. When real balances are a state variable in the investor 's optimization problem, there is a specific inflation-hedging portfolio. An investor hedges against inflation when the effect of real money holdings on the marginal utility of wealth is negative. We show that a decrease in real balances due to inflation has two opposite effects on the marginal utility of wealth. On the one hand, the decrease in real balances reduces consumption, which in turn raises the marginal utility and decreases the marginal cost of consuming: this explains why an investor would normally hedge inflation. On the other hand, the decrease in real balances tends to increase the marginal cost of consuming. When this second effect dominates, we have the somewhat surprising result that the investor reverse-hedges inflation.