The Demand for Currency Relative to Total Money Supply

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THE DEMAND FOR CURRENCY RELATIVE TO THE TOTAL MONEY SUPPLY1

PHILLIP CAGAN

University of Chicago

THE public's demand for currency as a fraction of the total money supply has long interested economists as well as bankers. Under fractional- reserve banking, a withdrawal of deposits in (non-bank) currency reduces bank reserves and, unless reserves were previously in excess of the desired level or are otherwise replenished, forces a multiple contraction of earning assets and deposits. A deposit of currency augments bank reserves and allows a multiple expansion of earning assets and deposits. Thus the public's conversion of its cash balances from one form to the other, if not offset by other factors, alters the aggregate amount of the money supply as well as its composition. This effect on the money supply, unlike changes in bank reserve ratios or issues of Treasury and Federal Reserve money, is not subject to direct control by the monetary authorities. However, it can be offset by appropriate open market operations of the central bank and so is an important consideration in planning monetary measures.

There has been a good deal of speculation about the factors that underlie the demand for currency, but empirical inquiry has been limited chiefly to seasonal variations in demand because adequate data covering a long period were not available. New estimates of the United States money supply since 1875 remedy this deficiency.2Figure 1 shows the ratio of currency to the total money supply3 annually from 1875 to 1955. This article deals with the behavior and determinants of this ratio, mainly in the long run. A separate study of its short-run cyclical movements is in preparation.

The currency ratio has varied considerably. It was above 30 per cent just after the resumption of gold payments in 1879 and gradually declined to just over 7 per cent by 1930. Subsequently it rose to 20 per cent during World War II and

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1
This study is part of a project of the National Bureau of Economic Research under the over-all direction of Milton Friedman. His suggestions guided the work in its initial stages and helped greatly to improve the final product. Generous help was also received from Anna J. Schwartz, whose extensive knowledge of this material made her comments especially useful. Solomon Fabricant, Edward J. Kilberg, Morris Mendelson, and George J. Stigler also made useful comments. Not all these people entirely agreed with the interpretation of some of the findings, and it should not be assumed that they accept the conclusions without reservations.

The paper has been approved for publication as a report of the National Bureau of Economic Research by the Director of Research and the Board of Directors of the National Bureau, in accordance with the resolution of the board governing National Bureau reports (see the Annual Report of the National Bureau of Economic Research). It is reprinted, with the addition of an appendix on data and sources, as No. 62 in the National Bureau's series of Occasional Papers.

2
These estimates were developed by Milton Friedman and Anna J. Schwartz. See The Supply of Money in the United States, a forthcoming publication of the National Bureau of Economic Research.
3
Currency is defined as the hand-to-hand notes and coin issues outside banks of the United States Treasury, Federal Reserve banks, and (until 1935) national banks. The total money supply is currency plus the demand and time deposits of all commercial banks held by the non-banking public.

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