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Precautionary Balances and the Velocity of Circulation of Money

  • Miquel Faig
  • Belén Jerez

The low velocity of circulation of money implies that households hold more money than they normally spend. This behavior is explained if households face uncertain expenditure needs, so that they have a precautionary motive for holding money. We investigate this motive in a search model where households are subject to preference shocks. The model predicts that the velocity is not only low but also interest elastic. The model closely fits United States data on velocity and interest rates (1892-2004). The empirical analysis reveals a dramatic reduction in precautionary balances towards the end of our sample, which is important for policy issues.

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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-188.

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Length: 37 pages
Date of creation: 31 Mar 2006
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-188
Contact details of provider: Postal: 150 St. George Street, Toronto, Ontario
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  1. Aleksander Berentsen & Gabriele Camera & Christopher Waller, . "Money, Credit and Banking," IEW - Working Papers 219, Institute for Empirical Research in Economics - University of Zurich.
  2. Moen, E.R., 1995. "Competitive Search Equilibrium," Memorandum 37/1995, Oslo University, Department of Economics.
  3. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  4. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
  5. Guillaume Rocheteau & Randall Wright, 2003. "Money in Search Equilibrium, in Competitive Equilibrium, and in Competitive Search Equilibrium," PIER Working Paper Archive 03-031, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  6. John W. Kendrick, 1961. "Productivity Trends in the United States," NBER Books, National Bureau of Economic Research, Inc, number kend61-1, August.
  7. Ricardo Lagos & Randall Wright, 2004. "A unified framework for monetary theory and policy analysis," Staff Report 346, Federal Reserve Bank of Minneapolis.
  8. Miquel Faig, 2004. "Divisible Money in an Economy with Villages," Levine's Bibliography 122247000000000159, UCLA Department of Economics.
  9. Lucas, Robert E, Jr & Stokey, Nancy L, 1987. "Money and Interest in a Cash-in-Advance Economy," Econometrica, Econometric Society, vol. 55(3), pages 491-513, May.
  10. Hodrick, Robert J & Kocherlakota, Narayana R & Lucas, Deborah, 1991. "The Variability of Velocity in Cash-in-Advance Models," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 358-84, April.
  11. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  12. Kiyotaki, Nobuhiro & Wright, Randall, 1989. "On Money as a Medium of Exchange," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 927-54, August.
  13. Faig, Miquel & Jerez, Belen, 2005. "A theory of commerce," Journal of Economic Theory, Elsevier, vol. 122(1), pages 60-99, May.
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