RDP 2013-01: Currency Demand during the Global Financial Crisis: Evidence from Australia 1. Introduction

Late 2008 witnessed an intensification of turmoil in financial markets around the world. As this unfolded, there was a substantial surge in holdings of Australian currency. The increase in total banknote demand in late 2008 was 12 percentage points larger than the normal increase in demand at that time of year, amounting to an additional $5 billion on issue (Figure 1).

History has shown that periods of increased demand for currency can be associated with losses of confidence in financial institutions and even runs on deposits. This paper examines the recent episode of heightened currency demand to further the understanding of the behaviour of the Australian public and banks in times of financial stress.^[1] In particular, we look at what drove the surge in currency demand and whether it was of broader significance to the economy. We also consider whether high-frequency currency demand data contain useful real-time information during crises. Understanding currency demand is also important for the role of the Reserve Bank of Australia (RBA) in issuing currency, especially given that it is difficult to increase banknote production at short notice.

There were many events in late 2008 both internationally and domestically that are likely to have had an effect on currency demand. Internationally, Lehman Brothers collapsed and financial markets became increasingly turbulent, while several other major financial institutions were placed into receivership or required emergency liquidity measures. In Australia, as confidence fell and the Australian dollar depreciated, there were a number of policy responses: the RBA cut the interest rate on overnight cash sharply; the Federal Government enacted a guarantee of deposits with authorised deposit-taking institutions (ADIs); and the Federal Government announced, and distributed, stimulus payments to households equivalent to 1.7 per cent of annual GDP. At the same time, there was a sizeable increase in the demand for currency.

Traditional models of currency demand focus on interest rates and income as key explanatory variables. Lower interest rates reduce the opportunity cost of holding currency and so make it relatively more attractive. Increases in income tend to be associated with increases in the demand for currency to conduct transactions. An alternative (but not mutually exclusive) explanation for the rise in currency demand in late 2008 is that precautionary demand increased as a result of at least some depositors being concerned about the stability or liquidity of banks during the financial crisis.^[2] Also, financial institutions may have increased their precautionary demand for currency in anticipation of rises in demand from their customers. However, bank deposits increased during the period in question, so it is clear that there was no large-scale loss of confidence in the banking sector.

To investigate the relative importance of these factors we estimate traditional models of currency demand and then expand them to include new variables that may be important during financial crises. We also include transaction cost variables to avoid possible model misspecification. We find that the increase in currency holdings in late 2008 was substantially larger than can be attributed to the normal response to interest rate cuts and the fiscal stimulus payments, and so may have been due to precautionary demand.

The demand for different denominations of banknotes can help to identify the different causes of the increase in currency demand. We posit that precautionary demand for banknotes should result in a disproportionate increase in demand for high-denomination banknotes because they are more likely to be used as a store of value than low-denomination banknotes. This is consistent with the relative rises in currency holdings of different denominations observed in late 2008.

The remainder of the paper is structured as follows. Section 2 provides some background on currency demand in past financial crises, followed by a more detailed description of the Australian experience during late 2008 to early 2009. Section 3 discusses currency data in more detail. Econometric modelling to control for the effects of interest rates and income is presented in Section 4, followed by a conclusion in Section 5.

Footnotes

Currency supplied by the RBA is perfectly elastic so actual quantities of currency in circulation can be thought of as demand. [1]

We are using precautionary demand to mean demand for currency as a precaution against difficulties in accessing currency in the future due to a banking crisis. This is a different sense to Keynes' use of precautionary demand to mean a precaution against future requirements for currency to make unexpected transactions. [2]