Demand and Supply of Currencies of Small Denominations: A Theoretical Framework
Economic history reveals that different countries over different time periods suffered from severe shortage of currencies of small denominations. Due to the frequency and severity of these incidents, first Cipolla (1956) and later Sargent and Velde (2002) named this phenomenon as ``the big problem of small change''. The paper presents a theoretical framework to understand ``the big problem of small change''. It specifies demand and supply equations of currencies of small denominations. Both demand and supply equations emerge out of an optimization framework. Demand functions for small denominations are obtained from a linear expenditure system. Our main contention is that economic agents would like to hold a fixed number of small changes, independent of their respective total cash holdings. However, in our model the fixed quantity is influenced by the probability that in a currency transaction, the counterparty would be able to provide the small change if needed. The supply function is derived from an optimization problem where the central bank balances its operational cost with the probability that an individual would be able to carry out ``small'' transactions independently, without the help of counterparty. In this demand-supply framework, the probability that a randomly chosen individual in an economy would hold certain currency combinations is interpreted as ``price''. We attempt to show that in a dynamic environment, such interaction could be understood by specifying a cob-web type model where expectations are formed based on previous period's experience. As an operational rule, it is proposed that the central bank should increase the supply of small denominations at a rate marginally above the growth rate of economically active population and stop minting as soon as some of the small denominations start return in the currency chest. We also suggest how demand for ``small change'' could be estimated from the ``lifetime'' of the ``smallest'' denomination.
Volume (Year): 9 (2011)
Issue (Month): 2 (July)
|Contact details of provider:|| Web page: http://www.jqe.co.in/societyhome.html|
More information through EDIRC
|Order Information:|| Postal: Managing Editor, Journal of Quantitative Economics, Indira Gandhi Institute of Development Research (IGIDR), Gen. A.K. Vaidya Marg, Goregaon (E), Mumbai 400 065 , INDIA|
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Laurence Ball & N. Gregory Mankiw, 1993.
"Relative-price changes as aggregate supply shocks,"
93-13, Federal Reserve Bank of Philadelphia.
- Ball, L. & Mankiw, G.H., 1992. "Relative-Price Change as Aggregate Supply Shocks," Harvard Institute of Economic Research Working Papers 1609, Harvard - Institute of Economic Research.
- Laurence Ball & N. Gregory Mankiw, 1992. "Relative-Price Changes as Aggregate Supply Shocks," NBER Working Papers 4168, National Bureau of Economic Research, Inc.
- Telser, L. G., 1995. "Optimal denominations for coins and currency," Economics Letters, Elsevier, vol. 49(4), pages 425-427, October.
- Wallace, Neil, 2003. "Modeling Small Change: A Review Article," Working Papers 9-03-3, Pennsylvania State University, Department of Economics.
- Sumner, Scott, 1993. "Privatizing the Mint," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(1), pages 13-29, February.
- Cramer, J. S., 1983. "Currency by denomination," Economics Letters, Elsevier, vol. 12(3-4), pages 299-303.
- Wallace, Neil, 2003. "Modeling small change: a review article," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1391-1401, September.
- Kaushik Bhattacharya & Himanshu Joshi, 2001. "Modelling currency in circulation in India," Applied Economics Letters, Taylor & Francis Journals, vol. 8(9), pages 585-592.
- Manjong Lee & Neil Wallace & Tao Zhu, 2005. "Modeling Denomination Structures," Econometrica, Econometric Society, vol. 73(3), pages 949-960, 05.
- Kaushik Bhattacharya & Himanshu Joshi, 2002. "An Almon Approximation of the Day of the Month Effect in Currency in Circulation," Indian Economic Review, Department of Economics, Delhi School of Economics, vol. 37(2), pages 163-174, July.
- Kohli, Ulrich, 1988. "A note on banknote characteristics and the demand for currency by denomination," Journal of Banking & Finance, Elsevier, vol. 12(3), pages 389-399, September.
When requesting a correction, please mention this item's handle: RePEc:jqe:jqenew:v:9:y:2011:i:2:p:123-139. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (D. M. Nachane)or ()
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.