Precautionary Money Demand in a Cash-in-Advance Model

Despite a plethora of studies in monetary economics regarding the study of inflation, interest rates, stock returns, and velocity of money, a model that helps to jointly characterize these interactions is still scarce in the literature. A key missing piece in most of the literature attempting such a characterization is idiosyncratic precautionary money demand, which is prevalent in the data. This paper presents a simple model where precautionary money demand arises due to heterogeneity in households' liquidity needs. In spite of its heterogeneous complexity, aggregation in the model is straightforward, this is one of the main contributions of the paper, and therefore an analysis of the models' implications can be undertaken when households' portfolio is composed of cash, government bonds, and equity. The empirical analysis is conducted separately for the time spans 1984.I-2007.IV and 2008.I-2019.IV. The model can capture important time-series properties that a model without the idiosyncratic feature is unable to achieve. However, the model falls short of providing an adequate match of some moments, especially in the second sub-sample of the analysis.