Norges Bank's management of cash inventories.

• Author: Aastveit, Knut Are

In order to fulfil its obligations regarding the supply of notes and coins, Norges Bank needs to hold cash inventories. The level of inventories must be considered with regard to ordinary and extraordinary circumstances. In order to predict demand and reduce the uncertainty concerning inventory requirements, sound models that can enhance the understanding of changes in cash circulation are required. The explanatory variables for cash demand can be divided into three different groups: general macro-economic variables, variables that express the competition between cash and deposits, and variables that may provide insight into the illegal economy. A newly developed model for cash demand shows that demand for actual cash is dependent on real consumption at the point of sale, bank interest rates and a negative linear trend that captures developments in the payment system, in addition to the historical value of real cash. The model-based forecasts show that demand for cash will increase in the next quarters before decreasing towards the end of 2006 and further through 2007.

1 Introduction

According to the Norges Bank Act, Norges Bank is required to issue notes and coins (statutory responsibility for issuing notes and coins). Under the Norges Bank Act, Norges Bank is also responsible for ensuring that cash is available (statutory responsibility for supplying cash). Responsibility for issuing notes and coins and the banknote monopoly entails issuing notes and coins in the amounts implied by demand and ensuring that notes and coins are available to society (see Eklund, Solberg and Veggum, 2005). Norges Bank's goal is to fulfil these obligations in an economical, efficient and secure manner.

In 2001, Norges Bank outsourced most of the services associated with cash storage and the handling of deposits and withdrawals from the central bank depots. Norges Bank is still responsible for procurement of banknotes and coins, as well as storage and transport associated with the central bank depots. For this reason, analysing future cash needs is an important task.

Section 2 of the article gives a brief introduction to the organisation of cash holdings in Norway. Section 3 explains the necessity of holding inventories of banknotes and coins. Section 4 discusses factors that affect the circulation of cash and section 5 explains the structure of a model for cash demand. The use of the model is then demonstrated in section 6. Section 7 discusses the model's importance in logistical planning.

2 Organisation of cash supply

The physical flow of cash may be divided into three steps: production, storage and circulation (see Chart 1). Production of coins takes place at the Mint of Norway, while Norges Bank is responsible for the production of banknotes. During the course of 2007, the printing works in Norges Bank will be closed, and thereafter production will take place externally. Storage is organised with a central cash distribution vault and five depots located around the country. The cash distribution vault is operated by Norges Bank, while Norsk Kontantservice AS (NOKAS) operates the depots on behalf of Norges Bank. The quantity of notes and coins in use in the community at any given time is often called the circulation of notes and coins, or cash circulation. (2) The cash circulation level changes when banks need cash and make withdrawals from Norges Bank, or when they have a surplus of cash and make deposits in Norges Bank. In this context banks operate to all intents and purposes as an intermediary between the public and Norges Bank. In practice, this means that it is the public's demand for notes and coins that determines the level of cash circulation.

3 The need to hold cash inventories

One of Norges Bank's goals is to fulfil its statutory responsibility for supplying cash in as secure and cost-efficient a manner as possible. This means that Norges Bank must be able to meet banks' demand for cash, both under normal circumstances and under more extraordinary circumstances. Total inventories required must be assessed in the light of both of these circumstances.

Uncertainty regarding future demand for cash affects estimates of holding levels. It is therefore important to have a sound understanding of which factors affect demand for cash and how these may affect demand in the future.

3.1 Supply capability under normal circumstances

There are various reasons for the need to hold cash inventories. Demand is seasonal, and the purpose of the stock is to help meet these demand fluctuations. The inventories are also held to deal with various types of uncertainty, such as other variations in demand and transport delays or supply delays.

When determining the appropriate level of operating inventories under normal circumstances, two needs are assessed: transaction stock and buffer stock.

* Transaction stocks serve to cover normal requirements during the period between one delivery and the next from the producer. On the basis of estimated demand for cash and expected destruction, the transaction stock is determined by minimising the sum of order, transport and storage costs. A large proportion of the production costs for notes and coins are fixed, which means that unit costs are reduced when the volume increases. On the other hand, larger volumes increase the capital tied up in the storage of cash. Transport is often costly due to security requirements and long distances. It will therefore be cost-efficient to exploit certain capacities during transport. By minimising total costs, one can determine the optimal order volume and the resulting size of the transaction stock.

* Buffer stocks serve as a buffer against uncertainty, primarily uncertainty regarding demand for cash. Not all uncertainty can be eliminated. This is why it is necessary to decide how much uncertainty the Bank should attempt to cover. We refer to this as choice of supply capability, i.e. the probability of being able to meet demand for a denomination when the transaction stock approaches the level where it needs to be replenished and until a new order arrives. The size of the buffer stock required grows exponentially in step with the supply capability required. The higher the supply capability, the higher the buffer stock. This in turn will affect stock holding costs. The optimal supply capability may be difficult to determine, but is a balance between increased costs and the consequences of stock depletion. The negative consequences of cash stock depletion are regarded as significant by Norges Bank. Consequently, the Bank aims to have a relatively high supply capability.

Inventory policy during normal circumstances can thus be expressed as the aim of minimising overall order, transport and storage costs in addition to setting targets for supply capability.

3.2 Emergency preparedness

The need to maintain emergency stocks in case of extraordinary circumstances is related to the public's cash requirements in such circumstances. Extraordinary circumstances are said to occur in the case of various forms of failure or disturbances in key public infrastructure, e.g. electronic payment systems. The size of the stocks that Norges Bank needs to hold in order to handle such situations is determined by what the Bank chooses to be prepared for and the degree of preparedness that is chosen.

3.3 Total cash inventories

Norges Bank's operating and emergency inventories may essentially be treated as two separate stocks. Norges Bank has...