The extrinsic value of low-denomination money holdings
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The extrinsic value of low‑denomination money holdings Allan Hernandez‑Chanto1 Received: 24 July 2019 / Accepted: 3 March 2020 © Society for the Advancement of Economic Theory 2020
Abstract We construct a search-theoretic model in which fiat money is available in low and high denominations and where agents can freely reconvert their money holdings using an exogenous technology that arrives stochastically. We show that if both the arrival rate of the exogenous technology and the discount rate are bounded from below and above, there exists an equilibrium in which low denominations have an extrinsic value in any trade. Furthermore, we show that if one-low-coin portfolios are worthless, two-low-coin and one-high-coin portfolios are traded at par. Keywords Convertibility · Denominations · Extrinsic value · Money holdings · Premium JEL Classification E50 · E52
1 Introduction Throughout history, the imbalances in the supply of low-denomination coins (bills) have entailed serious problems to trade in different regions. This has caused lowdenomination coins being traded with a premium over its face value in many historical episodes. A recent one occurred in Panama during the decade of the eighties. There, as a result of a major political and economic crisis, $300 million was withdrawn from the financial system. This forced banks to immediately borrow abroad and reduce their liquid assets to compensate for the loss of local resources. Furthermore, banks were closed and reopened later under several restrictions. In particular, the government imposed restrictions to withdrawals from checking and saving A. Hernandez-Chanto thankful to Ryan Baranowski, Pedro Gomis, Luis D. Rojas, Alberto Trejos, Neil Wallace, Randy Wright, and Cathy Zhang for valuable suggestions and comments. I have also benefited from the comments of audiences at The Chicago Fed Workshop and the University of Costa Rica. All the errors are my own. * Allan Hernandez‑Chanto [email protected] 1
School of Economics, University of Queensland, St Lucia, Brisbane, QLD 4072, Australia
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accounts and froze certificates of deposit. Most of the banks were only authorized to issue notes known as investment certificates (CEDIS) in minimal amounts of $1000 , which were used by national citizens as a method of payment, i.e., banks were forced to use illiquid instruments to inject money into the economy. At the same time, prices and wages declined as much as 20% in many sectors (MorenoVillalaz 1999). This environment, characterized by the scarcity of liquid assets and low prices, propitiated the trading of CEDIS at a discount of 15–25% over their face value, as well as the arbitrage of low-denomination money holdings through the exchange of $100 and $50 bills for $5 and $1 bills when Panamanians traded with foreign visitors. Even though foreign visitors provided convertibility of portfolios at the natural rate—i.e., at a factor of conversion equivalent to the ratio of the facial values of the denominations involved—a
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