Cuba’s Central Bank’s Resolution 111 issued in 2023, and explanations given by its new president on the Mesa Redondoa TV show, prove the lack of understanding they have about a key concept in any country’s monetary policy: demand for cash money. This simple formulation helps to show the factors that influence peoples’ money holdings and illustrates the essential relationships that need to be taken into account when making monetary policy decisions.
The amount of currency an economy needs depends on four key variables:
1. Transaction Value: This is linked to money’s function as a payment method. Money is used to buy and sell available goods and services for a certain price. Demand for money grows if there are more transactions (this can be calculated by real GDP growth) or if prices of goods and services increase as a result of inflation.
2. Interest rates: This is the price of the opportunity to keep money in its cash form. If interest rates increase, it’s an incentive for people to deposit their savings in a bank and discourages people from keeping cash.
3. Transaction costs, technological advances and payment systems: The evolution of financial technology (Fintech) and payment systems influence demand for money, because they reduce financial transaction costs and make it easier to convert savings into cash. For example, swipe cards, electronic payments and other digital means tend to reduce the need for physical cash.
4. Velocity of money circulation: This is the velocity at which money changes hands over a certain period of time. This variable includes many factors that influence people’s and companies’ preference for holding onto more liquid funds. It goes hand-in-hand with their expectations of the future of the economy, the informal market, uncertainty, etc. This is the most difficult variable to predict and changes erratically a lot of the time, making demand for money unstable.
By putting these four factors into Cuba’s current context, we are able to understand why demand for money has changed so drastically. Cash in circulation grew 10% every year between 2000 and 2017; but it grew at an annual rate of 86% between 2020-2022.
Rampant inflation and the devaluation of informal exchange rates increased the need for larger sums of money to pay for goods and services, and to buy foreign currency. While real GDP and the number of transactions have decreased, prices have multiplied on many occasions and more money is needed.
Nominal interest rates remain fixed, making them extremely negative in concrete terms. In other words, people are losing money by keeping it in the bank, as their purchasing power dwindles every day because of inflation. Banks haven’t made up for these losses with saving accounts by adjusting their rates to the current monetary situation in Cuba.
Transaction costs to withdraw cash at banks or at an ATM also encourage demand for money. Huge lines, out-of-date technology and intermittent telecommunication services are just another reason to keep cash outside of the bank.
The speed with which money circulates also explains increased demand for cash. Calculated using the nominal GDP, the velocity of cash circulation dropped 38% over the past five years, compared to the average recorded betwween 2000-2017. This downward spiral of cash velocity has been crystal clear since 2012.
It reflects a structural change in the economic system with the evolution of the private sector, but it can also be an indicator of greater informal activities and uncertainty. This change is being translated into a greater demand for cash so the Cuban peso can serve as a payment method and store of value.
A recessionary solution
In the explanations mentioned on Mesa Redonda, a concept as basic as demand for money isn’t highlighted. The financial logic behind Resolution 111 is based on an obsolete model of cash revenue and expenditure between state-controlled banks and households. The graph (without numbers) and analysis given on Mesa Redonda to show that money was leaving the banks and not coming back, is a very ‘80s take on assessing monetary policy. It isn’t in line with the structural changes that have been taking place within the Cuban economy.
With the diversification of labor, trade, markets, production and the private sector’s greater participation, the banks’ model of cash revenue and expenditure isn’t saying anything useful if it doesn’t also evaluate the deciding factors of demand for money. Cash doesn’t have to leave and come back to the banks. There is a changing and autonomous demand for money in households and the private sector that can’t be ignored.
If the Central Bank wants to have an influence on reducing demand for money, it will have to put a stop to rampant inflation, first and foremost. To do this, it needs to stop monetizing the huge fiscal deficit, which means implementing the macroeconomic stability program they announced. Another key factor of demand for money that they can change is interest rates. By increasing interest rates (at least in proportion to the inflation rate), they would be increasing the cost of holding onto cash.
But no. Administrative measures continue to be the plat du jour, no matter how much they write and say the opposite in I don’t know how many documents.
The Cuban Government has decided to apply a forced banking service and a swift digital payment system that needs to be implemented in just six months. They are expecting this to happen in a country with the most backward telecommunication infrastructures in the world and with one of the most underdeveloped banking and payment systems in the region, and with an aging society.
They not only seem to be ignoring the fact that advances in bank services and digital payment take years or decades, but that trust is also a key factor in these hopes. Not too long ago (2021), families saw how 80% of the value of their bank accounts vanished as a result of “Currency Reform”.
Today, almost no central bank is chasing specific objectives linked to the amount of cash in circulation. This was a widespread practice in previous decades, but it failed because of unstable demand for money and how difficult it is to predict what the “optimum” amount of cash is needed in an economy.
Central banks moved towards strategies that focused on inflation rates, interest rates and diversifying monetary transmission mechanisms. Demand for money has always been an endogenous variable in the economic and financial climate. Central banks provide the economy with all of the money it demands. If they don’t, they know that the consequences will be recessionary.
Money is like the oil that keeps the engine of the economy moving. If you don’t give it the oil it needs, it burns out. The worse thing is that we don’t have a magic wand to know just how much money the economy needs, it constantly changes and for a variety of reasons.
This hasty freeze on cash and a digital payment system proposed by Cuba’s Central Bank is extremely recessive, in its attempt to know how much money is needed in the economy or needs to return to the banks, ignoring the deciding factors of demand for money and the context that the private sector and households are engaging in.
It shows their greatest shortcomings in understanding how monetary policy works, as their explanations why a forced reduction of cash in circulation will help to stop inflation and keep the informal economy in check.
Ever since the 1990s, the Cuban Government hasn’t been able to provide a national convertible currency with an exchange rate in keeping with the country’s economic and financial reality. The economy has had to malfunction with partial dollarization, currency duality, multiple exchange rates, the overvaluation of the official exchange rate and exchange controls.
This cocktail of currency distortions now joins the inability, and now their rejection, to provide the cash the economy needs.
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