The relationship between interest rates and demand for hard cash

A blog post on MoneyIllusion provides an idea of the how monetary economics works.

Interest rates are the opportunity cost of holding cash. If you lower interest rates, people will choose to hold more cash. And yes, that means lower interest rates are contractionary, as I said in a number of recent posts. Here’s a graph showing the relationship between the demand for currency (as a share of GDP) and T-bill yields:

Notice that the two variables tend to move inversely. After 2008, the yield on T-bills fell close to zero, and the demand for cash soared from just over 5% of GDP to just over 7%. Today’s currency demand is about 40% larger than it would be had interest rates stayed at the levels of 2007.

Over the previous several decades, interest rates had been trending downwards from their 1981 high point, while the demand for currency had been trending upward from its 1981 low point. Prior to 1981, interest rates had trended upwards for many decades, while currency demand had trended downwards.

This isn’t to say that the two variables are perfectly (negatively) correlated. Other factors such as tax rates also impact currency demand. And it is costly for currency hoarders to quickly adjust their stocks of currency, as most currency demand is for things like tax avoidance. Thus the stock demand for currency responds gradually to changes in the opportunity cost of holding currency. It’s a much smoother time series.