Demand for Cash: An Econometric Study for India

Why do we use cash? This project assesses the factors affecting the persistent demand for currency (banknotes) in India. Past work in this domain has looked at factors such as interest rates set by the central bank, price levels, and growth of newer ways to make payments.

However, in the Indian context, policies such as demonetization were motivated by the use of cash in the ‘shadow’ economy, as well as counterfeit currency. We wish to examine whether this rationale is backed adequately by data; i.e. whether use of cash in India is indeed associated with payments and transactions outside the formal economy. To establish this, we need both an overall understanding of currency demand (using macroeconomic or economy-wide data) as well as individual-level data (i.e. how people like you and I use cash in our daily lives).

With such data, recent studies study technological and financial factors such as distance to nearest automated teller machines (ATMs), banking density, and surcharges for credit or debit card payments on cash use can be accounted for. However, very little research of this kind has been done in developing economies, especially India. Although a few currency demand studies (Nachane et al., 2013; Bhattacharya and Joshi, 2001) look at these issues in the Indian context, there is no data for conducting a microeconomic analysis. The Reserve Bank of India’s (RBI) policies related to managing cash, are thus currently unable to take this into account. Thus, one of the major evidence gaps relates to understanding India-specific factors that could affect the demand for cash.

A study of currency demand in India offers several opportunities to look at economic, social, and behavioural factors specific to India that have been previously unexplored. Given that cash appears to have value to individuals beyond simple financial reasons (e.g. gifts for festive occasions are typically made out in cash), India is ripe for a study of cash demand beyond what we currently know. This area also offers a way to inform future currency management policies (e.g. demonetization, introduction of new banknotes), as well as policies on developing payment systems in India. For instance, richer economies such as Australia and Canada make use of “contactless” payment cards (no authentication via PIN required), whereas such technology is yet to catch up in India.

Finally, understanding the importance of the quality of a banknote (longevity, endurance to wear and tear such as writing, tearing, crumpling common in India) is often underplayed when discussing the demand for cash. Thus, the project offers a look at both sides of the cash story: supply and demand.

Why does this matter for India? Our project will be the first in a developing country context (especially India) to empirically assess the economy-wide as well as the individual-level demand for cash, and examine the supply side issues in enabling sustainable currency use in India. We expect to produce a first-of-its-kind public-use data on payment methods used by individuals in urban India, empowering policymakers and academics researchers alike to explore further the current state of payment mechanisms and cash usage in India. The RBI’s Vision 2018 for Payments was suggested in light of the demonetization policy and would be informed by findings from our microeconomic analysis. Thus, both key components of the project (demand and supply) will address emerging needs and policy trends of the Reserve Bank of India.

So far, we have some findings from analysis that aim at uncovering newer insights on currency demand in the Indian context. At both the national and individual level, we find that growth of debit and credit cards, and electronic means of payment affect the demand for cash in India. Cash remains the most preferred mode of payment, but it is less used when other ways to pay are accepted. Similar to other countries, preliminary analysis show that smaller-value banknotes (Rs. 10, Rs. 20) circulate for a smaller period of time compared to larger notes (e.g. Rs. 500).

More technically, our aggregate model of currency demand finds that high-value currency in circulation is inelastic to growth of alternate payment instruments. Informality in the economy is associated with greater currency demand. Our micro analysis suggests that contextual factors do not significantly affect cash held, but that the size and purpose of the transaction, whether merchants accepted non-cash alternatives, and perceptions of usefulness of cash all affected the preference for cash as a means of payment. There are also additional behavioural factors such as the justification of tax evasion and trust that could vary significantly with cash held or preference for cash payments.

We, graduate research scholars of the IITB-Monash Research Academy, study for a dually-badged PhD from IIT Bombay and Monash University, spending time at both institutions to enrich our research experience. The Academy is a collaboration between India and Australia that endeavours to strengthen relationships between the two countries. According to its CEO, Prof Murali Sastry, “The IITB-Monash Research Academy was conceived as a unique model for how two leading, globally focussed academic organisations can come together in the spirit of collaboration to deliver solutions and outcomes to grand challenge research questions facing industry and society.”

He was bang on target. As an economist in training, my interest comes from understanding how people behave and react to changes in their environment. This project offered me a chance to examine something that is typically done using aggregate data and a “rational human” framework, but often has rich socio-cultural context (especially in India). It was also a challenge for me as I have previously only worked with microeconomic data and research problems.

Research scholar: Anirudh Tagat, IITB-Monash Research Academy

Research scholar: Demand for Cash: An Econometric Study for India

Research scholar: Prof Pushpa L Trivedi, Prof Greg Markowsky, and Prof Mehmet Özmen

Research scholar:

The above story was written by Anirudh Tagat. Copyright IITB-Monash Research Academy.

(Additional data collection for this project was supported via a grant award by the National Council for Applied Economic Research (NCAER), and the School of Mathematics, Monash University.)