Understanding the Cash Demand Puzzle

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We develop a model to explain a puzzling trend in cash demand in recent years: the value of bank notes in circulation as a percentage of GDP has remained stable despite decreasing cash usage at points of sale owing to competition from alternative means of payment such as credit cards. The main feature of the model is that cash circulates between economic activities where the substitutability between cash and other means of payment is uneven. Our model predicts that, once credit expands beyond a certain level, agents adjust their cash management practices in response to further credit expansions, causing the velocity of cash to slow down, so that the demand for cash can remain flat despite diminishing cash transactions.

DOI: https://doi.org/10.34989/swp-2014-22