New Zealand banks noticed an increase in cash withdrawals by households since the day of lockdown announcement. Banks believe this might be due to the panic stockpiling of nervous households as was mentioned in the article.
In this post I want to discuss what drives the households to behave in this way, and how this comes into our thinking about economics and monetary policy.
I have to admit, when the lockdown announcement took place, I was one of those nervous households who decided to cash out money from my bank. My personal reasoning for that was the scars left by defaulting banks during the collapse of the Soveit Union, when my parents lost all their savings because one of the main banks failed.
However, what are the economic consequences of this behaviour? We might say that this is saving behaviour – but the people withdrawing their funds were already saving them. Instead people are hoarding cash for some reason. This is likely due to fear of bank failure (my reason), but a similar thing can happen even when individuals shift funds from a long-term savings vehicle to near monies (eg a checking account). Examples of this are:
- people cash out money or move it to a chequing account due to uncertainty of their employment status in the future
- people decide to shift allocation of transactions, for instance, waiting until the end of the month to make bulk purchases.
In both cases the increase in demand for cash is also an increase in demand for liquidity. So what does this mean for our broader economy?
Why are we concerned?
Cash hoarding affects the circular flow of money in the economy. We all know the circular flow diagram, and how real transactions are made between buyers and sellers. However, these transactions involve a countervailing exchange of money. So as Matt noted we can think of this both in terms of the money flow (MV) and the nominal income flow (PY). Sudden hoarding will reduce velocity for the same stock of money, thereby leading to a reduction in nominal incomes. How do we think about this?
The hoarding comes from money demand. So let’s think about that with a fixed (real) money supply. Here money demand declines with the interest rate as the opportunity cost of money (the return available from illiquid assets) is higher.
Above the change in money demand could be due to:
- An increase in output. It is that shift, where people require greater money balances to facilitate these transactions which defines the traditional LM curve.
- An increase in precautionary saving held in near monies form (cash, or a chequing account that a bank struggles to use as an effective basis for loans).
Here, with a fixed stock of money, both of these things would push up interest rates. Hence this forced a movement up the IS curve and a reduction in output.
But this isn’t how a central bank responds to this change – a central bank like the RBNZ accommodates any increase in money demand initially by setting an interest rate peg. As a result, such a surge in demand for money doesn’t lead to rising interest rates unless the central bank decides not to accommodate it!
What does it mean for us?
In a broad sense having an interest rate peg instead of a quantity of money peg means that we don’t have drops in output due to tight monetary policy – in a sense. The central bank accommodates shifts in money demand, thereby automatically meeting any change in the money supply required to meet liquidity needs.
However, the use of QE and other instruments to support liquidity show that this process isn’t always easy – and a fixed interest rate peg doesn’t always translate into sufficient liquid funds to meet this demand for liquidity. As a result, monetary policy has a very real role trying to ensure that this need is met.
But there is one caveat- the increase in uncertainty associated with something like the current COVID crisis does not just shift that LM curve – it also shifts the IS curve left. I have discussed this in terms of investment before.
If the central bank is able to manage liquidity issues with its interest rate peg appropriately, then all that matters is the question of whether there is sufficient demand for goods and services – a question that requires different answers (changes in the interest rate, discretionary fiscal policy). In an IS/LM diagram such monetary policy is represented as a “shift” in that curve.
As a result, the example of people hoarding cash gives us a great insight into the dual roles the RBNZ is playing in both managing money markets and stabilising economic activity – and gives us a framework to consider the two clearly.