On Precautionary Money Demand

I solve a model of precautionary money demand where households face idiosyncratic shocks to their marginal utility of consumption. The household needs to decide the portfolio allocation between money and shares of a... [ view full abstract ]

I solve a model of precautionary money demand where households face idiosyncratic shocks to their marginal utility of consumption. The household needs to decide the portfolio allocation between money and shares of a stochastic dividend. Once households have chosen their portfolio allocation, they then ascertain their actual marginal utility of consumption (urgency of consumption), for which only money can serve as a medium of exchange.  I take data on households' portfolio allocation from the flow of funds and examine whether the model can mimic their behavior when fed with actual data for dividends. I focus on the period 1995-2016, which covers the last two U.S. recessions, a time in which stock market dividends fluctuated considerably. I find that in spite of the model's unique driver-fluctuating dividends-the fraction of liquid assets it delivers reasonably tracks the data close to the recessive periods. Households in the model are quite sophisticated in their optimization behavior; hence, the result of this paper warns against some views that have emerged since the Great Recession that traditional macro models emphasizing rationality are useless in understanding complex financial decisions.