Limited Commitment and the Demand for Money
University of Zurich, Department of Economics, Working Paper No. 199
44 Pages Posted: 24 Jul 2015 Last revised: 9 Mar 2016
Date Written: February 19, 2016
Understanding money demand is important for our comprehension of macroeconomics and monetary policy. Its instability has made this a challenge. Common explications for the instability are financial regulations and financial innovations that shift the money demand function. We provide a complementary view by showing that a model where borrowers have limited commitment can significantly improve the fit between the theoretical money demand function and the data. Limited commitment can also explain why the ratio of credit to Ml is currently so low, despite that nominal interest rates are at their lowest recorded levels. In a low interest rate environment, incentives to default are high and so credit constraints bind tightly, which depresses credit activities.
Keywords: Money demand, financial intermediation, limited commitment
JEL Classification: D9, E4, E5
Suggested Citation: Suggested Citation