Money Supply Estimation, Foreign Exchange Risk, and Other Challenges Facing the Palestinian Economy in the Absence of a National Currency

The absence of a national currency and the circulation of more than one foreign currency subject the Palestinian economy to serious challenges. The lack of a national currency makes it very difficult to estimate money supply, and hence the Seigniorage lost to the issuers of the circulating foreign currencies. It also increases the vulnerability of the Palestinian economy to economic shocks while limiting the ability of Palestinian policy makers to deal with these shocks.

As a result of these factors, the circulation of more than one currency makes the Palestinian economy highly vulnerable to foreign exchange risk. In this paper we attempt to estimate Palestinian currency in circulation, money supply (M1), and the currency composition of both, as well as the Seigniorage generated by the Palestinian economy. We estimate Palestinian currency in circulation by using Jordanian currency-GDP ratio and the medium currency-GDP ratio for Arab countries. We evaluate the accuracy of our estimates by assessing the strength of Palestinian currency demand using wage currency composition and wage frequency data for Palestinian workers.

We estimate Palestinian money supply by combining our estimates for Palestinian currency in circulation with current account deposits at the Palestinian banking system. We estimate the seigniorage generated by the Palestinian in 2012 by calculating the change in currency holdings in 2012 from its 2011 level, and adding the result to the change in total cash holdings by commercial banks in the same year. We develop a methodology to separate currency demand into its medium of exchange and store of value components.

Using this methodology, along with our estimate for Palestinian currency holdings, we calculate the currency composition of Palestinian currency holdings and money supply. We also investigate the vulnerability of the Palestinian economy to external shocks and foreign exchange risk, as well as possible mechanisms to decrease such vulnerability, including direct targeting of external shocks. Additionally, we analyze the impact of foreign exchange risk on households and firms and the effectiveness of commercial banks as financial intermediaries as well as possible regulatory mechanisms to reduce such impact.