Precautionary demand for money is motives for holding money to provide a buffer against unexpected events that might require cash. In a precautionary motive, you worry about what might happen. You may need money to anticipate if you are sick or lost your job. You never know what will happen. And the higher the uncertainty, the more likely you are to save money.
But now, the motive for precaution may be less important, namely, because it is easier to turn assets into cash. Also, people have credit cards now, so you don’t need to put some money into the mattress; if you have an emergency, you can use a credit card.
The precautionary motive is one of the three reasons for asking for money. The other two motives are for transactions and speculation.
- The transaction motive is money held to facilitate daily payments.
- Speculation motive. It is related to the function of money as a store of value. Because there are many alternative assets, in general, money demand is positively correlated with asset prices and negatively associated with the risk of those assets. For example, people expect stock prices to fall, then most rational people will sell shares and save money.
Determinants of precautionary demand for money
In general, the demand for money as a precaution positively correlated with average transaction size, total transaction volume, and, therefore, also to overall gross domestic product (GDP). Price expectations also affect its value. When people expect the price of goods to increase in the future, they will reduce the demand for money just in case and spend money on products now before the actual price increase.
