Limited Commitment and the Demand for Money

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