A while back, Nick Rowe had a post about the option value of cash. Rowe asserts that cash gives a real option to do anything. At first, I didn’t see a problem with this, but as part of my ongoing debate with Silas Barta, I’ve thought a bit more about this. I think Rowe’s point is technically correct, but misleading because he neglects to mention that all reasonably liquid stores of value give this option value. Reasonably liquid stores of value, primarily financial assets, can give you the option to purchase whatever you like later on. Now cash is more liquid than any other asset, so on the time scale of hours or days only cash gives you the option value you want, but on reasonable time scales (enough time for your brokerage firm to wire you the money) many financial assets will do.

It can also be misleading for another reason; it can be tempting to think that it’s cash itself that creates that option value, that this option free in the sense that it is available regardless of the state of the world. However, money is just a kind of asset. If the option of saving in terms of money sends false signals about the profitability of actual short run saving (in the form of trading promises or of doing actual real investment), this can cause problems. In the usual case, where cash pays 0% interest and market rates for short run saving is positive, say 2%, this leads people to inefficiently avoid holding money. In the case where cash pays 0% interest and market rates for short run savings are negative, say -2%, this causes the opposite problem people try to hold too much cash.

If the option of waiting a short period of time is very valuable, so everyone wants to do it, this may cause short run rates to be very negative and the 0% cash option to be very distortionary.

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