Precautionary versus Transactions Motive: The Effects of Aggregate Fluctuations in a Monetary Economy

Models where money arises due to a transactions motive imply that an increase in aggregate activity will raise the demand for money. Models where money arises due to money being the most preferred form of precautionary savings imply that a decrease in individual uncertainty will lower the demand for money. Therefore, the effect of an aggregate shock on the demand for money depends upon shock’s impact on both aggregate activity and individual uncertainty. This paper addresses these two possibly contradictory effects of aggregate shocks on the demand for money. The model used is a variant of the Lagos-Wright (2003) model of money, where money’s use is derived from the underlying frictions in the economy. The Lagos-Wright model is a tractable model by the presence of a general good that does not allow for a precautionary motive for holding money. The model of this paper modifies Lagos-Wright by introducing a set of constrained agents who cannot produce the general good, but still face individual shocks, so they have a precautionary motive for holding money. The model is solved by slowly increasing the measure of agents who are thus constrained from an initial measure of zero to see the effects that increasing the relative importance of the precautionary motive for money has on the aggregate economy. Current results are pending.