Modelling currency demand in a small open economy within a monetary union

Currency management is a core business function of a central bank. Understanding the factors driving cash demand and its denomination structure are vital for the smooth functioning of the economy. We pursue an analytical framework which allows to model the demand for each denomination individually as well as to capture the interactions between them, both over the short- and long-run. The approach builds on the DSUR estimator for the long-run relationships coupled with a SUR ECM for modelling the short-run dynamics. The focus is on a small open economy within the euro area monetary union. Such a context adds dimensions which go beyond the traditional drivers considered in the previous literature. In particular, the importance of currency migration through tourism flows is highlighted. Furthermore, the interconnections between demand for different denominations are found to be quite significant and the heterogeneous role of the determinants across denominations is documented.