Precautionary Demand for Money in a Monetary Search Business Cycle Model,” manuscript

We investigate the quantitative implications of precautionary demand for money for business cycle dynamics of velocity of money and other nominal ag-gregates. There is a standing challenge in monetary macroeconomics to account for such dynamics, as previous business cycle models that have tried to incor-porate demand for money have failed to generate realistic predictions in this regard. Our stance is that part of this failure results from the fact that de-mand for money in those previous models is deterministic, since agents in them face only aggregate risk, whereas we believe idiosyncratic risk to be important as well. We conduct the exercise inside a stochastic cash-credit good model, where cash-good consumption is subject to idiosyncratic uninsurable preference shocks. We find that precautionary demand for money plays a substantial role in accounting for business cycle behavior of velocity of money and other nominal variables such as inflation and nominal interest rates. In the result analysis, we isolate the precautionary demand channel to demonstrate its quantitative role in the model. In addition, we compare our results to several existing monetary models that do not have idiosyncratic uncertainty, to show that we improve substantially on their performance. ∗For extensive discussions and helpful comments, we thank Fernando Alvarez, Manuel Amador