Journal of Economic PerspectivesVolume 7, Number 4Fall 1993Pages 175-184

The Case of the Missing Currency

Case M. Sprenkle

n late 1992, currency in tbe bands of tbe public was close to $300 billion, representing nearly 30 percent of Ml. One would tbink tbat an economic variable of tbis magnitude would be well-analyzed and well-understood. Quite tbe contrary. Tbe last serious survey of currency boldings commissioned by tbe Federal Reserve were in 1984 and 1986; tbey are reported by Avery et al. in tbe February 1986 and May 1987 Federal Reserve Bulletin. Tbese surveys indicate tbat currency demand is not at all understood. Probably tbe most intriguing and newswortby result of tbese surveys was tbat about 80 percent of currency boldings simply could not be explained. Despite tbe stir of general interest tbat followed tbose studies, economists bave sbown little lasting interest in considering tbe implications of tbese findings. Tbis paper is written in tbe bopes of stimulating more interest in currency bebavior.

Who Holds the Currency?

Tbe survey results sbowed tbe aggregate bousebold demand for currency to be $23.3 billion, of wbicb $20 billion was for transactions purposes and $3.3 billion for "boarding." In 1986, currency in tbe bands of tbe public was $177 billion, so tbat bousebold demand was about 13 percent of tbe total. Business boldings of currency estimated by Anderson (1977) and updated by Sumner (1990) for 1986 amounted to about $5 billion. Tbus, tbe bousebold and business demands for currency summed to only about $28 billion or under
Case M. Sprenkle is Professor of Economics, University of Illinois, UrbanaChampaign, Illinois.

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16 percent of the total of $177 billion. There are only three possibilities for holders of the remaining 84 percent of the currency: the domestic illegal (or "underground") economy, children under the age of 18 who are not included in the survey, or foreigners. Since the media tends to highlight illegal activity, many believe that the underground economy is a major holder of currency, and its holdings do appear significant. The 1987 Federal Reserve Bulletin article cites an Internal Revenue Service report of 1983, Income Tax Compliance Research, that suggests currency holdings for the underground economy of about $9 billion. This figure is almost one-third the total amount held by households and businesses which is, indeed, a large amount. However, adding up the household, business and illegal demands for currency, we only get a total of $37 billion explained out of a total of $177 billion. Thus, even with large illegal holdings, only about 21 percent of currency holdings are explained, which leaves about $140 billion in the hands of children under 18 years and foreigners. Although children may have more currency than many would think good for them, no one seriously suggests children as the chief holders, leaving foreigners as the likely suspects for holding U.S. currency. The rough magnitude of the missing money obtained from the Federal Reserve survey has been confirmed with quite different estimating techniques. Sumner (1990) obtains the same type of results through analysis of seasonal demands and the demands for currency by individual denominations. He, and others in the literature he cites, refer to the unexplained portion as simply "hoarding," but by whom is unclear. The Federal Reserve study (1987) and Sumner (1990) are reluctant to attribute large amounts of the missing currency to foreigners' holdings. The primary reason for their reluctance seems to be that the missing currency is unaffected by dollar exchange rates or the U.S. position in the world economy. "The survey estimates, however, suggest that the missing proportion did not change between 1984 and 1986 despite the sharp depreciation of the dollar against Japanese and European currencies" (Federal Reserve Bulletin. 1987, p. 191). A secondary reason is that per capita cash holdings are also high for other developed nations, so that U.S. currency holdings are not necessarily unique or mysterious. I believe that these arguments against large foreign holdings of currency are misguided. That foreign holders of U.S. currency should significantly adjust their holdings with changes in the U.S. exchange rate suggests substantial sophistication. The very terms economists use, like "Foreign Currency Traders and Markets," may lead us astray here. After all, foreign currency markets rarely trade currency, but rather swap other assets denominated in various currencies. Sophisticated economic agents presumably would not hold foreign currency at all, just foreign-denominated assets. For this reason, even though the U.S. dollar remains the world's reserve currency par excellence, this does not necessarily suggest that other actual hard currency is not widely circulated.

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Table 1

Currency of Industrialized Countries in 1992

(1) (2) Population (millions) (3)

Country

Currency (billions of dollars) 11.38 10.71 13.44 18.26 4.19 2.03 49.83 113.04 6.07
.06

Per capita currency (in dollars)

655

Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy

17.34 7.82 9.85 26.99 5.14 4.99 56.64 64.12 10.12

.26

1368 1365
677 817 406 880

1763
600 232 666

Japan
Netherlands New Zealand Norway Portugal Spain Sweden Switzerland U.K. U.S. Total

2.35 62.09 276.11 19.69

.65

4.98 5.04 49.89 10.56 21.15 30.79 277.20 989.51

3.52 57.66 123.92 15.06 3.38 4.26 10.58 39.02 8.64 6.79 57.41 252.69 786.20

1076 2228 1308

191

1171
475

1278 1222 3116

537

1096

Source: International Monetary Fund, International Financial Statistics, October 1992.

The Argentinean taxi driver or the Algerian bellhop would like to have the American tourist or businessman's dollars, but would also appreciate the Italian's lire or the Japanese's yen if that is who is arriving. The foreign worker is happy to take home dollars if working in the United States, or deutschmarks if working in Germany. The point is that compared with the "soft" domestic currency in many countries, any "hard" developed country currency is worth obtaining both as a store of value and a medium of exchange. If this sort of desire for hard currency is the driving force, it is not surprising that the per capita currency holdings for the United States do not greatly differ from other hard currency countries. In fact, in mid-1992, the per capita U.S. currency holding was only tenth-highest out of the 22 industrialized countries, as shown in Table 1. Unless people in other hard currency countries are carrying around far, far more currency than U.S. citizens, domestic demand is highly unlikely to explain a major portion of their total currency demand, either.

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From this perspective, the notion that foreigners do in fact hold the major share of developed countries' currency does not seem unreasonable. Furthermore, once the currency leaves the issuing country, it is unlikely to return quickly. Instead it will be circulated abroad in competition with the local currencies. The "dollarization" of Latin America is one example of this phenomenon. Equally of interest may be the "yen-ization" (yenning?) of southeast Asia, the franc-ization of northern Africa, and the deutschmarking and Swiss franc-ing of just about everywhere.

International Implications: Which Debt Crisis?

Consider an American travelling overseas and buying some good or service using U.S. currency. The traveller immediately obtains the goods or services, and the foreigner may, of course, obtain an equal value of goods or services by spending the dollars. But if the residents of the foreign country do not spend the dollars in the United States and the currency circulates abroad, the effect is that no residents of that country receive goods and services from the United States equal to what was obtained by the American traveller. U.S. residents considered en toto have received current goods and services at the expense of foreigners considered en toto. Similarly, for a guest worker in Germany taking deutschmarks back to the home country, Germany will have immediately received tbe value of the guest worker's output, but the foreign country considered en toto will not receive anything from Germany, unless or until the deutschmarks are returned to Germany. In effect, the "seigniorage" that the currency-issuing country's government (the U.S. or German government in these examples) obtains as an interest-free loan ends up being a loan from the residents of a foreign country. The advantage to a country of having a hard currency is readily apparent. To the extent that the developed countries' currencies are held by residents of other developed countries, these loans may not be considered of great importance. But to the extent that the holders of foreign currency are residents of less developed countries, the problem is immediate and acute. It means that the less developed countries as a group are giving interest-free loans to the developed economies. These loans might be considered the second international debt crisis. How large might this second crisis be? The answer depends on estimating the total foreign holdings of the currencies of the developed economies, and then estimating the proportion of these holdings held by less developed country residents. The data in Table 1 suggest two possible ways of estimating total foreign holdings. First, it might be assumed that the developed countries on average have the same percentage of unexplained currency in the United States79 percent. Given this assumption, with total developed country currency in the hands of the public of $990 billion, total foreign holdings would be

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$782 billion. Second, the data in Table 1 show two clear outliers, Iceland and New Zealand, for which per capita currency holdings are very low. These two countries are very small, relatively isolated, and do not have significant numbers of foreign workers. It is doubtful that much of their currency is in foreign hands. Thus, we might assume that their per capita currency holdings of about $215 might represent the domestic per capita currency holdings of all developed countries. The total developed country population of 786 million, multiplied by $215 per capita, gives $169 billion for the total domestic demand. Subtracting the $169 billion from the total of $990 billion yields foreign holdings of $821 billionremarkably close to the $782 billion estimate obtained from the first method. Thus, two quite independent methods of estimating foreign holdings of developed countries' currency yield the same ballpark estimates. Moreover, as shown below, there is reason to believe the U.S. figure of 79 percent unexplained currency holdings will have increased from 1986 to the present, bringing the two estimates even closer. The figure of $782 billion implies that the "second" international debt crisis is potentially quite large. For comparison, the total amount owed from less developed to developed countries is somewhere between $800 and $900 billion. Since no direct data exists as to what proportion of developed country currency is held by less developed country holdings of developed country currency, the reader is free to choose, but my own suggestion is that the proportion is large. After all, developed country holdings of other developed countries' currencies should be primarily for convenience in transacting. Major holdings of foreign "currencies" should instead be held as foreign denominated deposits or other interest bearing assets. Two caveats should be mentioned about these results. First, some preliminary work by Porter (1992) finds that only something over 60 percent of U.S. currency holdings are unexplained, rather than the nearly 80 percent described here. The estimates are obtained by comparing U.S. and Canadian data. The method used, however, assumes no Canadian currency is foreign-held and to the extent that Canadian currency is indeed foreign-held, the estimates obtained will be biased downwards. Second, several developed economies issue very large denomination banknotes which for a few countries account for a significant share of the value of total banknote circulation. For example, Boeschoten and Fase (1992) point out that the Netherlands issues Fl.lOOO notes worth $563, which accounted for 44 percent of the total value of currency in 1987. By tracking these large denomination notes, their methods leave only 40 percent of these banknotes unexplained. (Interestingly, they estimate illegal domestic holdings at about one-third of total domestic holdings, which is the same figure as the IRS estimate for such holdings in the United States.) In addition to the Netherlands, they show that in 1987, a German 1000 DM banknote (then worth $632) accounted for 24 percent of the value of total banknote circulation, and Switzerland issued a 1000 Fr banknote (then worth $782) accounting for 45 percent of the value of

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total banknote circulation. Canada and Sweden also issue very large denomination banknotes, but they account for only a very small percentage of total circulation. Since the work on circulation by denomination of Porter (1992) and Sumner (1990) only includes U.S. denominations up to the generally issued $100 banknote, it may be inappropriate to use their findings for circulation of the very large denomination banknotes. Instead, we might apply the Boeschoten and Fase figure of 40 percent unexplained for these banknotes as applying not only to the Netherlands but also to Germany and Switzerland. Adjusting the figures accordingly reduces the total developed country currency that is foreign held by somewhat over 2 percent. These two caveats suggest a figure only somewhat lower than 80 percent unexplained. Even if diligent research succeeded in "finding" significant extra domestic currency holdings, the size of the second international debt crisis remains very large, as do the real costs to the less developed countries.

Domestic Implications: Some Microeconomics

The microeconomics of household currency demand appears to be so trivial that it has been largely regarded as a solved problem. In the standard formulation, rational economic agents will only desire currency for transactions purposes and transactions needs will be a (simple) function of income and tbe interest rate foregone by holding currency. Among recent efforts along this line, Whitesell (1989) has developed a model jointly optimizing with respect to maximum size of transaction using currency and number of times currency is obtained. However, the Federal Reserve survey results suggest that this theoretical approach does not actually describe household currency demand. Consider the results from the surveys reproduced in Table 2, which show how much currency people acquire at a given time, how much they have at the time of acquisition, tbe average currency they hold, and the average currency they spend. The first three columnsMedian Dollars Acquired, Median Dollars on Hand Before Acquisition, and Mean Average Currency Balanceall appear roughly the same across income levels. In short, if the typical household obtains $100 of currency, its average holding is $50 plus the small amount on band when additional currency is obtained, no matter if it spends $1000 or $100 per month using currency. However, the Mean Monthly Currency Expenditures does rise with income. The most likely explanation for these results lies in a different type of household optimizing process than that which economists would usually suggest. Households maximize utility (rather than minimize costs) in cash management by deciding on a standardized optimal amount of currency to obtain. Too much currency on hand is uncomfortable because of the risk of theft or loss.

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Table 2

Household Currency Demand

Median Dollars Acquired
Family Income

Median Dollars on Hand Before Acquisition 1984 10 15 15 20 20 1986 5 7 10 10 15

Mean Average Currency Balance 1984 97 105 92 105 101 1986 120 98 120 102 126

Mean Monthly Currency Expenditure 1984 297 421 412 464 528 1986 331 440 433 514 473

1984 80 100 63 75 100

1986 100 70 100 65 80

< $10,000 $10,000-19,999 $20,000-29,999 $30,000-49,999 > $50,000

Source: 1984 data, Federal Reserve Bulletin, February 1986, Table 11, pg. 100 and Table 12, pg. 102. 1986 data. Federal Reserve Bulletin, March 1987, Table 12, pg. 189.

Too little currency on hand is uncomfortable because of inconvenience. The usual transaction costs do not enter into this process; particularly, the value of time apparently does not enter in, since this would presumably result in still higher currency holdings for upper income households. Some ad hoc survey results support and strengthen the case. For some time now I have surveyed faculty, executive MBA students (average age 35) and local business and professional people as to their currency habits. (A summary of the results is available on request from the author.) The results suggest that households, when obtaining currency, have a standardized and round number in mind. For most the amount is $100; for a few substantially more, $150 to $200, and for a few others $50 to $75. Currency is obtained as needed when the amount on hand falls fairly lowabout $20. For most, these standardized amounts have stayed constant for a long timeabout a decade or so. These findings suggest that not only do currency holdings fail to rise with income in the cross section, but in addition any income elasticity of currency holdings over time is small and subject to very long lags. Finally, there appears to be little or no interest elasticity, despite most respondents having some type of interest bearing checking account. This should not be surprising, since the interest gains from economizing on the holding of currency are negligible. For example, halving the currency amount acquired from $200 to $100 (and thus doubling the number of trips to the bank or ATM) would increase the yearly interest return at the current rate of about 3 percent by $1.50, or enough for one extra Big Mac per year. And if the interest rate doubled, you could have an extra Big Mac for your spouse. Thus, the household transactions demand for currency seems independent of income, the fraction of income spent using currency, and interest rates. In fact, it is a constant in the short run. In (substantially) longer runs, it should have some income elasticity. Also, if currency per household is the relevant

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figure, then total currency held will clearly depend on the rate of household formation.

Domestic Implications: Some Macroeconomics

The fact that currency demanded by households for transactions purposes is a constant does not mean that this household transactions demand for narrow money en toto also has a constant term. Given a constant expenditure rate for simplicity, T is total expenditures per period and C is the standardized currency amount obtained, currency holdings will average C/2 and checkable accounts T/2 - C/2. The total transactions demand then is T/2 and income elastic, since 7 is a function of income. If checkable account holdings vary with interest rate differentials, then the household transactions demand for money is also interest elastic. However, the constant currency demand results in the same but negative constant term for checkable accounts. Thus the usual assumption of money demand functions without a constant will be inappropriate for demand functions for individual money components. In particular the use of log/semi-log functions for either currency or checkable accounts will lead to misspecification. Foreign demand for currency will be similar to the household transactions demand for currency in that it will be independent of the issuing country's income and interest rates. In fact, the instability and misspecification of currency demand functions caused by household transactions behavior is small compared with that arising from the far larger foreign holdings of currency. And the foreign holdings of currency result in a constant term in the total transactions demand for money since they are not offset by a reduction in checkable accounts, as is the case for domestic households. In the United States in 1986, currency in the hands of the public was 26 percent of Ml. Using the estimate that the missing currency was 79 percent of total currency in the hands of the public, foreign holdings could be over a fifth of Ml. Furthermore, the importance of this factor is increasing over time, both because currency is increasing as a percentage of Ml and because a larger share of the currency is foreign held. Gurrency increased from 26 percent of Ml in 1986 to 29 percent in mid-1992. If we assume, given the microeconomic behavior of households, that household transactions demand increased at the rate of household formation, and the other domestic demands (business and illegal) at the rate of income growth, total domestic currency demand will have increased from about $37 billion in 1986 to about $47 billion in 1992. With currency in the hands of the public at $277 billion, domestic demand accounts lor only 17 percent of currency, leaving 83 percent estimated to be held by foreigners. By this measure, current foreign holdings of currency account for 24 percent of Ml.

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Having updated the estimated foreign holdings of U.S. dollars to 83 percent in 1992, rather than the 79 percent estimated in 1986, we can re-estimate the total amount of developed country currency that is foreign-held, assuming that the other developed countries on average have the same percentage as the United States. With total developed country currency in the hands of the public of $990 billion (from Table 1), average foreign holdings equal to 83 percent of this, yields $822 billion as being foreign held. This is within $1 billion of the total estimated by assuming developed countries' domestic currency demand equal to that of Iceland and New Zealand; the two independent methods of estimation yields not only the same ballpark estimates, but exactly the same estimate. While the exactness of this match must be partly coincidence, it is surely a suggestive coincidence, to say the least. Glearly, the instability and a large constant term (technically a large degree of nonhomogeneity) in currency demand creates a problem for money demand equations. There may be serious questions as to the realism of many of the results recently obtained from macro models which assume homogeneity (no constant) in money demand equations. To the extent that the missing currency is foreign-held, the situation poses problems for policy-makers, as well. Since foreign-held currency is not a medium of exchange for the issuing country, increases in currency in the hands of the public in developed countries then should not be considered as money supply increases for monetary policy decisions. The Federal Reserve and other central banks should ignore such increases as being basically irrelevant to domestic monetary conditions. These implications suggest a rather startling proposition. Since the inclusion of currency for money demand functions and macro models as well as for monetary policy considerations causes problems, why should currency be considered part of the money supply? Why not define Ml to be simply current Ml less currency in the hands of the public, and by analogy do the same for broader measures of money (for which, however, the constant term will be relatively smaller and therefore less troublesome). This would save money demand functions as well as macro models, and in addition give the Federal Reserve a more useful and less misleading figure to use in the conduct of monetary policy. For somewhat related reasons. Green ward and Stiglitz (1991) have also suggested removing currency from Ml. Just as developed countries should find it useful to redefine Ml, the same factors should be considered by less developed countries. Where a poor country has a substantial concentration of foreign currency, this currency should be included in the domestic money supply and included in monetary policy decision-making. Such inclusions will emphasize the constraints on possible gains from expansionary monetary policies. For example, to the extent that hard foreign currency exists in the economy in direct competition with domestic currency, attempts of the government to gain from inflating the domestic currency may not succeed. As an example, consider Argentina. In 1986, with a

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relatively modest inflation rate of about 90 percent, per capita domestic currency holdings were about $100 whereas in 1989, with true hyperinflation, domestic currency per capita holdings had fallen to under $29. The disadvantages of lost seignorage for a country with a soft currency and large inflation rates are as obvious as the advantages in obtaining seignorage by having a hard currency.

Anybody Interested in Currency?

The study of currency seems to ofTer something for almost every area of economics. For the micro theorist, there is the question of rather unexpected household behavior. For the macro theorist, there are many implications of money demand functions with large constant terms. For the monetary policy specialist, there are questions of appropriate monetary policy and money definitions. For development economists, there are questions of the size of seignorage losses and appropriate policy, given competition from hard currencies. International economists can tackle those questions, along with any implications of these findings for capital flows and exchange rates. And even for economic historians, are there not similarities in the past? For example, how much of Spain's coinage from New World gold remained part of Spain's money supply? To all, then, good hunting!
Thanks are due to William Maloney, Salim Rashid, Joseph Stiglitz, Timothy Taylor, and James Tobin for comments on a previous draft.

References
Anderson, Paul S., "Currency in Use and in Hoards," New England Economic Review, Federal Reserve Bank of Boston, March/April 1977, 21-30. Avery, Robert B., Gregory E. Elliehausen, Arthur B. Kennickell, and Paul A. Spindt, "The Use of Cash and Transaction Accounts by American Families," Federal Reserve Bulletin, February 1986, 72, 87-108. Avery, Robert B., Gregory E. Elliehausen, Arthur B. Kennickell, and Paul A. Spindt, "Changes in the Use of Transaction Accounts and Cash from 1984 to 1986," Federal Reserve Bulletin, March 1987, 7i, 179-96. Boeschoten, Willem C, and M. G. Martin, "The Demand for Large Banknotes," Journal of Money, Credit, and Banking, August 1992, 24S, 319-37. Greenwald, Bruce, and Stiglitz, J. E., "Towards a Reformulation of Monetary Theory," CAFFEE Lecture presented at the University of Rome and the Bank of Italy, Rome, April 1991; Cambridge University Press, forthcoming 1993. Porter, Richard D., "Estimates of Foreign Holdings of U.S. CurrencyAn Approach Based on Relative Cross-Country Seasonal Variations," working paper. Board of Governors of the Federal Reserve System, 1992. Sumner, Scott B., "The Transactions and Hoarding Demand for Currency," Quarterly Review of Economics and Business, Spring 1990, 30:1, 75-89. Whitesell, William C, "The Demand for Currency versus Debitable Accounts: A Note," Journal of Money, Credit and Banking, May 1989, 27:2,246-51.