Precautionary Money Demand in a Cash-in-Advance Model

Abstract

While numerous studies in monetary economics explore inflation, interest rates, stock returns, and money velocity, a model seamlessly linking these interactions remains elusive. One crucial omission in this literature is idiosyncratic precautionary money demand, a prominent feature in the data. This paper addresses this gap by presenting a simple model where precautionary money demand arises from heterogeneous household liquidity needs. Despite its intricate heterogeneity, the model allows straightforward aggregation, enabling analysis of its implications for household portfolios composed of cash, government bonds, and equities. The empirical analysis spans the period 1959.I–2022.I. Notably, the model captures crucial time-series properties that models without the idiosyncratic element fail to achieve.