The case for a financial approach to money demand

Xavier Ragot

Money remains a mysterious object for economists though it constitutes the principal asset of so many households around the world. The motives for holding on to money are not only of intellectual interest, they are also crucial for understanding the evolution of the current crisis. Since 2008, central banks have injected massive amounts of money into helping economies to stabilise – much more in England and the United States than in Europe. Where does all that money go? Who keeps it and why? The consensus view among economists is that economic agents keep hold of money in order to consume: money is thus a means of exchange. However, this view of money does not seem very convincing here.
In this article, Xavier Ragot uses, for the first time, data from American and Italian households in order to discover the reasons for holding on to money. The data, collected every four years, relate to financial and monetary worth, covering all American and Italian households. The first surprising result is that household savings habits are very different depending on their level of consumption: households often hold on to more money than they need, which tends to invalidate the means of exchange thesis. On the other hand, savings are close to household levels of wealth, that is, to their total worth. Money is used as reserve value, along with other more remunerative financial assets. How are we to understand this behaviour? Ragot shows that we can understand monetary choices by introducing a number of substantial financial imperfections that the economic literature usually treats separately. First, households face the risk of serious income fluctuations (chiefly,the risk of unemployment). In economic terms, that can be summed up coyly as the incompleteness of the insurance markets. Second, there is a cost to entering into financial markets. This cost is not only financial, it also appears to be cognitive. Buying bonds through investment companies requires time for analysis that some households are not prepared to spend. Taking these financial imperfections into account, we can better understand the empirical distribution of money.
The article concludes that we cannot separate monetary theory from the financial economy. Money exists because of numerous “imperfections” that must be included in economic analysis. Finally, in this way, the distributive effects of monetarist policies (“who loses, wins” when monetary policy changes) can be analysed with more finesse.
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Original title of the article : “The case for a financial approach to money demand”
Published in : Journal of Monetary Economics, Vol. 62, Pages 94–107 - March 2014
Available at : http://www.sciencedirect.com/science/article/pii/S0304393213001256
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