Precautionary money demand in a business-cycle model

• Precautionary demand for money is significant in household data.
• Precautionary money demand dramatically affects nominal business cycle dynamics.
• Omitting precautionary demand results in wrong values of key parameters.
• Without precautionary money demand, welfare costs of inflation are understated.

Precautionary demand for money is significant in the data, and may have important implications for business-cycle dynamics of velocity and other nominal aggregates. Accounting for such dynamics is a standing challenge in monetary macroeconomics: standard business-cycle models that have incorporated money have failed to generate realistic predictions in this regard. In those models, the only uncertainty affecting money demand is aggregate. We investigate a model with uninsurable idiosyncratic uncertainty about liquidity need. The resulting precautionary motive for holding money produces substantial improvements in accounting for business-cycle behavior of nominal variables, at no cost to real variables.