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Precautionary Balances and the Velocity of Circulation of Money


  • We are grateful to Masao Ogaki and two anonymous referees for helpful comments and suggestions, as well as to participants in the 9th World Congress of the Econometric Society, the Midwest Macro Meetings, and the Canadian Economic Association Meetings. We are also grateful for the financial support of SSHRC of Canada, Fundación Ramón Areces, Comunidad de Madrid (project 06HSE0175-2004), and Spanish DGCYT (project SEJ2004-07861 and Ramón y Cajal Program). Finally we benefited from the assistance of Kerstin Aivazian. The usual disclaimer applies.


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 velocity is not only low but also interest elastic. The model closely fits U.S. data on velocity and interest rates (1892–2004). The empirical analysis reveals a dramatic reduction in precautionary balances toward the end of our sample, which is important for policy issues.