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.