Understanding Household Demand for Cash

When disruption occurs and the past is no longer a reliable starting point and guide for the future, understanding the fundamentals is important. A recent paper published in CESIFO working papers (8574 2020) adds to our knowledge of household demand for cash.

The paper was written by Hans-Eggert Reimers, Friedrich Schneider and Franz Seitz with the title, ‘Payment Innovations, the Shadow Economy and Cash Demand of Households in Euro Area Countries’. 

Its starting point is that insufficient research has been done to explain why the ratio of euro notes in circulation to GDP has increased by 2.5 times between its launch in 2002 and 2019. Even with 30% of euro notes circulating abroad, this increase remains unexplained. This paper starts with private households.

Hypotheses

The authors argue that households are the key to understanding this, since it is they rather than retailers, financial institutions or the government who hold cash (this could change if negative interest rates are introduced).

A literature search covers what is known, or has been investigated to date, and this is used to create four hypotheses that the authors go on to test:

1. The larger the size of the shadow economy, the more cash will be used by households.

2. The more cash substitutes as payment innovations are available, the less cash will be held.

3. The drivers for cash are independent from the size of the economy.

4. Access to cash is important for consumers to realise their payment preferences.

Modelling

The modelling is based on comparing total net issuance against a number of variables: 

• Transaction variables (real private consumption). 

• Opportunity cost (interest rates on fixed term deposits). 

• Shadow economy (using latent Multiple Indicators Multiple Causes – tax rates, degree of regulation, level of employment). 

• Payment variables (number and value of cards, cashless POS (proxy for cashless alternatives). 

• POS terminals (proxy for retail cash acceptance). 

• Number of ATMs.

Results

It is the first ever study which looked at cash holdings of private households in all euro area countries from 2002 to 2019 within a panel cointegration framework. The report is an economist’s delight as it explains the data used, the modelling approach and the results. Overall, it is confident that it could demonstrate that the hypotheses are valid.

It concluded that: 

• Interest rates are not a significant determinant of cash demand in the euro area. 

• The quantitative importance of the shadow economy is modest. 

• The transaction variable is significant. 

• Cashless alternatives exert negative influence (as more options are available, people switch away from cash).

• Access to cash via ATMs is important to realise payment preferences – allow the ATM network to shrink and cash will reduce with it. 

• The size of the country did not change the results.

Reading the paper raises the question that if COVID leads to significant levels of unemployment, then that may turn out to be an important cash driver. Equally as GDPs contract, the transaction variable will lead to lower cash usage. Do they cancel each other out? As with every research paper ever written, the final conclusion is that more research is needed!