Precautionary Balances and the Velocity of Circulation of Money

The observed low velocity of circulation of money implies that households hold more money than they normally spend. A natural explanation for this behavior is that households face uncertain expenditure needs, so they have a precautionary motive for holding money. We investigate the precautionary demand for money in a search model where households are subject to preference shocks. The model predicts that the velocity of circulation of money is not only low but also interest elastic. The model closely fits United States data on the velocity of circulation of money and interest rates that span the period 1892-2003. The empirical analysis reveals a dramatic reduction in precautionary balances towards the end of our sample, probably linked to innovations in the information technology. This drop in precautionary balances is crucial for important issues of monetary economics such as the elasticity of the demand for money and the welfare cost of inflation.