Monetary Policy and Models of Currency Demand

Abstract

Two types of currency in circulation models are identified: (1) a first generation derived fromthe theory of money demand and (2) a second generation aimed at producing daily forecastsof currency in circulation. In this paper, we transform the currency demand function into aVAR to capture the dynamic link between interest rates and the demand for cash. We alsoapply ARIMA modeling to forecast the daily currency in circulation for Brazil, Kazakhstan,Morocco, New Zealand, and Sudan. Our empirical work shows that some of the conclusionsin the economic literature on the impact of interest rates on the demand for currency do notnecessarily hold, and that central banks would benefit from running both generations ofcurrency in circulation models. The fundamental longer-run determinants of the demand forcash are distinct from its short-run determinants.