A Simple Model of the Precautionary Demand for Money

Abstract

In the early 1950's the emphasis in the study of the demand for money switched from the partially accepted idea of a speculative demand for money based on uncertainty to the certainty based transactions demand. Then on re-examination, the speculative demand was gradually acknowledged to be theoretically unsatisfactory. The reason for the rejection was simply that as long as short term assets were available they would dominate money held for speculative purposes in the balanced portfolio.1 The third category in Keynes's triad, the precautionary demand for money, is now coming under scrutiny and it may be that this is where the uncertainty which is most relevant to the demand for money will come to rest.2 As Harrod has remarked [1, 171-3], it makes considerable sense to emphasize the precautionary motive over the speculative motive--not only in terms of the importance of the volume of money balances held for each reason, but also in order to provide a sensible basis for the interest sensitivity of the demand for money. It is the purpose of this paper to describe a simple model of the precautionary demand for liquid assets which gives an account of the determination of the quantity of precautionary balances of any asset and which stresses the relationship of money held for precautionary purposes to other liquid assets. It will be shown that the determination of the equilibrium precautionary money balance is part of a wider process of determining precautionary liquidity balances involving more than just one or two assets. The rates of interest on various assets will be seen to play important roles in determining desired precautionary asset balances but with only one rate of interest affecting precautionary money balances for the individual. One might therefore wish to conclude that the precautionary demand should join with the transactions demand for money to replace the speculative demand (the early Keynesian favorite) as the primary source of the interest elasticity of the demand for money.8 Much of the work in monetary economics and in the study of the demand for money in particular has become quite complex. Whether additional mathematics helps advance the theory or provides a barrier to entry is a well debated subject, not debated here, but the graphical approach of the paper is quite simple and perhaps provides another example of the valuable use of very basic concepts. An immediate problem is what one means by the precautionary demand for money. It is not unrealistic to remark that each of us