Expanding Behavior of the Currency Ratio

The general outline of the movements of the currency ratio c since 1892 is shown in Figure 1. As you can see, several episodes stand out:

1. The declining trend in the ratio from 1892 until 1917, when the United States entered World War I

2. The sharp increase in the ratio during World War I and the decline thereafter

3. The steepest increase in the ratio that we see in the figure, which occurs during the Great Depression years from 1930 to 1933

4. The increase in the ratio during World War II

5. The reversal in the early 1960s of the downward trend in the ratio and the rise thereafter

6. The halt in the upward trend from 1980 to 1993

7. The upward trend from 1994 to 2002

To be worthwhile, our analysis of c must be able to explain these movements. These movements, however, will help us develop the analysis because they provide clues to the factors that influence c.

A natural way to approach the analysis of the relative amount of assets (currency and checkable deposits) people want to hold, hence the currency-checkable deposits ratio, is to use the theory of asset demand developed in Chapter 5. Recall the theory states that four categories of factors influence the demand for an asset such as currency or checkable deposits: (1) the total resources available to individuals, that is, wealth; (2) the expected return on one asset relative to the expected return on alternative assets; (3) the degree of uncertainty or risk associated with the return from this asset relative to the alternative assets; and (4) the liquidity of one asset relative to alternative assets. Because risk and liquidity factors have not changed independently of wealth and expected returns and lead to similar conclusions on the historical movements of c, we will focus only on how factors affecting wealth and expected returns influence c.

Effect of Changes What is the relative response of currency to checkable deposits when an individuals in Wealth resources change? Currency is a necessity because it is used extensively by people with low incomes and little wealth, which means that the demand for currency grows proportionately less with accumulation of wealth. In contrast, checkable deposits are held by people with greater wealth, so checkable deposits are less of a necessity. Put another way, as wealth grows, the holdings of checkable deposits relative to the holdings of currency increase, and the amount of currency relative to checkable deposits falls, causing the currency ratio c to decline. A decrease in income will lead to an increase in the amount of currency relative to checkable deposits, causing c to increase. The currency ratio is negatively related to income or wealth.

Effect of Changes The second factor that influences the decision to hold currency versus checkable in Expected deposits involves the expected returns on the checkable deposits relative to currency

Returns and other assets. Four primary factors influence expected returns (and hence the cur rency ratio): interest rates on checkable deposits, the cost of acquiring currency, bank panics, and illegal activity.1

Interest Rates on Checkable Deposits. By its very nature, currency cannot pay interest. Yet banks can and do pay interest on checkable deposits. One measure of the expected return on checkable deposits relative to currency is the interest rate on checkable deposits. As this interest rate increases, the theory of asset demand tells us that people will want to hold less currency relative to checkable deposits, and c will fall. Conversely, a decline in this interest rate will cause c to rise. The currency ratio is negatively related to the interest rate paid on checkable deposits.

Between 1933 and 1980, regulations prevented banks from paying interest on most checkable deposits,2 and before 1933, these interest rates were low and did not

1Changes in interest rates on other alternative assets (such as U.S. Treasury bills) could have a differential effect on the demand for currency versus the checkable deposits, resulting in some effect on c. However, the evidence for this effect is weak.

2Although banks could not pay interest on checkable deposits, they provided services to their checking account customers that can be thought of as implicit interest payments. Because these services changed only slowly over time, these implicit interest payments were not a major factor causing the demand for checkable deposits to fluctuate.

undergo substantial fluctuations. However, since 1980, banks have been allowed to pay any interest rate they choose on checkable deposits, suggesting that fluctuations in these rates can now be an important factor influencing c movements.

Cost of Acquiring Currency. If currency is made easier to acquire, thereby lowering the cost of using it, then in effect its expected return rises relative to deposits and the currency ratio c should rise. Lowering the cost of acquiring currency leads to a rise in the currency ratio. The explosion of ATMs in recent years has indeed made it easier for depositors at banks to get their hands on currency and should thus have increased its use, raising c.

Bank Panics. Our discussion of interest-rate effects suggests that they did not have a substantial impact on c before 1980. You might conclude that expected returns have had little importance in determining this ratio for most of its history. Figure 1 provides us with a clue that we are overlooking an important factor when measuring expected returns solely by the interest rates on assets. The steepest rise in c occurred during the Great Depression years 1930-1933, when the banking system nearly collapsed. Legend has it that during this period, people stuffed their mattresses with cash rather than keep it in banks, because they had lost confidence in them as a safe haven for their hard-earned savings. Can the theory of asset demand explain this phenomenon?

A bank failure occurs when the bank is no longer able to pay back its depositors. Before creation of the FDIC in 1933, if you had an account at a bank that failed, you would suffer a substantial loss—you could not withdraw your savings and might receive only a small fraction of the value of your deposits sometime in the future. The simultaneous failure of many banks is called a bank panic, and the Great Depression years 1930-1933 witnessed the worst set of bank panics in U.S. history. From the end of 1930 to the bank holiday in March 1933, more than one-third of the banks in the United States failed.

Bank panics can have a devastating effect on the expected returns from holding deposits. When a bank is likely to fail during a bank panic, depositors know that if they have deposits in this bank, they are likely to suffer substantial losses, and the expected return on deposits can be negative. The theory of asset demand predicts that depositors will shift their holdings from checkable deposits to currency by withdrawing currency from their bank accounts, and c will rise. This is exactly what we see in Figure 1 during the bank panics of the Great Depression period 1930-1933 and to a lesser extent 1893 and 1907, when smaller-scale bank panics occurred. The conclusion is that bank panics lead to a sharp increase in the currency ratio. Bank panics have been an important source of fluctuations in this ratio in the past and could be important in the future.

Illegal Activity. Expected returns on checkable deposits relative to currency can also be affected by the amount of illegal activity conducted in an economy. U.S. law allows government prosecutors access to bank records when conducting a criminal investigation. So if you were engaged in some illegal activity, you would not conduct your transactions with checks, because they are traceable and therefore a potentially powerful piece of evidence against you. Currency, however, is much harder to trace. The expected return on currency relative to checkable deposits is higher when you are engaged in illegal transactions. Hence when illegal activity in a society increases, there is an increase in the use of currency relative to checkable deposits, and c rises. There is a positive association between illegal activity and the currency ratio.3

Looking at Figure 1, what types of increases in illegal activity would lead to an increase in c? Beginning in the 1960s, c began to climb—-just when the illegal drug trade began to experience phenomenal growth. Because illegal drug transactions are always carried out with currency, it is likely that the rise in drug trade is related to the rise in c. Supporting evidence is the current huge flow of currency into southern Florida, the major center for illegal drug importing in the United States.4 Other illegal activities— prostitution, black markets, gambling, loan sharking, fencing of stolen goods, the employment of illegal aliens—could also be sources of a higher currency ratio.

Another interesting set of movements in c are the two increases during both world wars, which are associated with large increases in income taxes. Income taxes were raised substantially in 1917 to help finance Americas entry into World War I. Although income tax rates were reduced after the war, they were again raised substantially during World War II to finance that conflict—never to return to prewar levels.

Increases in c when income tax rates rise can be explained in the following manner: Higher tax rates promote the evasion of taxes. When income tax rates rise, the incentive is high to evade taxes by conducting transactions in cash. If you receive an unreported cash payment for some service (for example, as a cab driver, waiter, or doctor), it is less likely that the Internal Revenue Service can prove that you are understating your income. If you are paid with a check or credit card, you would be wise to declare the income. The conclusion is clear: Higher tax rates will lead to a rise in c.

Not only does income tax evasion explain the rise in c during the two world wars, but it also helps explain the rise in the 1960s and 1970s. This may seem surprising because the income tax rate schedule was not raised during this period. However, the burden of income taxes was increasing because the American income tax system is progressive (as income increases, the tax rate rises). A rising price level in the 1960s and 1970s raised the nominal income and pushed more individuals into higher tax brackets (a phenomenon called bracket creep). This meant that the effective tax rate increased even though the tax schedule was unchanged. As a result, incentives increased to evade paying taxes by not declaring income, and people would avoid the use of checkable deposits. In other words, the expected return on checkable deposits fell, so c rose.

Increased tax evasion and other illegal activities not only reflect an increase in the currency ratio but also imply that more income will go unreported to the government. The result is an understatement of statistics on economic activity such as gross domestic product (GDP), which measures the total production of goods and services in the economy.

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