Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Should We Subsidize the Use of Currency?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Should We Subsidize the Use of Currency?

Article excerpt

Three types of money are provided monopolistically by the government in the United States: coin, currency, and reserve balances with Federal Reserve Banks. Together, they make up the monetary base. Although it is common to think of government money as virtually costless to produce, the real resource costs are substantial, as shown in Table 1. (Table omitted) In 1991 the cost of providing currency was $393.2 million, most of which was incurred in verifying and sorting deposits of used currency and replacing unfit notes with new currency.

Under current arrangements, banks can deposit used currency and withdraw fit currency at par. Thus currency costs are not borne directly by banks, but instead are funded out of general government revenues.(1) True, restrictions on banks' deposit and withdrawal of currency help limit Federal Reserve costs, but these costs are not borne by users. In contrast, all of the costs associated with the provision of reserve balances are recovered through "service fees," as mandated by the Monetary Control Act of 1980.(2)

This article examines whether the Fed should continue to subsidize the use of currency. In particular, I argue that the Fed should charge a currency deposit fee, effectively paying less than par when converting currency into reserve balances, and should remove the rationing constraints on currency deposits and withdrawals. This recommendation should not be surprising, since it follows from standard economic reasoning. The costs of a government-provided service should, in general, be paid by the users to ensure that use is efficient.

However, I argue that a partial subsidy is desirable, in the sense that the deposit fee should be less than marginal cost. The reasoning is again standard. There is likely to be a "market failure" that makes the private willingness to pay for fit currency less than the social benefits of fit currency. The market failure arises because currency generally trades at par, regardless of the quality of the note, due to the inconvenience of quality-adjusted currency prices. As a result, willingness to pay is less than the social benefits and the Fed should subsidize the provision of currency quality by charging less than marginal cost. In no case, however, should the deposit fee be zero; efficiency of the division of currency processing between banks and the Fed requires a strictly positive fee.

In what follows I focus solely on currency policy, even though coin use is similarly subsidized and the arguments against its free provision apply with equal force.

1. SOME BACKGROUND ON THE MANAGEMENT OF GOVERNMENT MONEY(3)

Depository institutions can hold reserve account balances at a Federal Reserve Bank. These reserves are book-entry demand deposits that can be transferred to other banks. Reserve account balances are also used for automated clearing- house transactions in which recurring payments are made via prearranged wire transfers. Federal Reserve Banks charge fees for transfers of reserve balances and generally recover all of the associated costs.

A branch or office of a bank may withdraw currency and coin from a Federal Reserve Bank, deducting the par value of the withdrawal from its reserve balance. Deposits of currency and coin are credited at par. In both cases the bank pays for transportation, generally via an armored carrier service.

Incoming deposits of currency at Federal Reserve Banks are processed on high-speed equipment that removes wrong denomination and counterfeit notes and verifies the number of notes in the deposit. In addition, the equipment re- moves and destroys "unfit" notes that have become soiled in circulation.(4) The remaining "fit" notes are repackaged and stored. Withdrawals of currency are met with fit used notes and newly printed notes from the Bureau of Engraving and Printing. Banks are not allowed to request new notes, but must accept the mix that is sent to them. Coins are deposited and withdrawn in bags of standard size and are verified by weighing. …

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