Understanding Cash as a Store of Value

Given how much cash is issued but held as a store of value, a paper entitled ‘Cash Money as a Saving Mode’ from Tampere University in Finland is useful and interesting. ¹

If one goes back to basics, starting with the classical quantity theory of money, the price level in the economy depends directly on the amount of active money in the circulation. The velocity of money moving around the economy is driven by economic activity. The theory does not deal with the inactive nature of money, although concepts such as precautionary savings and cash used as a means of savings are long-established.

Economists have understood that holding cash is useful to the owner in exactly the same way as if the cash was being used to buy goods or services. Just like any product, the benefit of holding cash has a diminishing marginal usefulness and it can also have positive cross-over effects.

Holding cash reserves provides insurance against the accidental volatility of illiquid assets, which come with a degree of risk and uncertainty depending on what form they are held in. It has also been argued that holding cash reserves allows people to enjoy the benefits of other products. Knowing that funds are readily available allows people to enjoy the moment with less concern.

Reaction to uncertainty

When there is significant uncertainty, and the paper cites the 2008 financial crisis, the pandemic and Russia’s invasion of Ukraine as examples, holding cash reserves is a rational response. It can also be an irrational response. The ‘money illusion’ is a tendency to think in terms of nominal rather than real monetary values. For an economist, nominal monetary values should not have a role in rational market behaviour.

In this context the paper aims to analyse rational and irrational motives to save money and to understand the consequences of holding cash when faced with uncertainty. For example, if people choose to hold cash, what is the impact on illiquid savings and on their investment in education.

The authors created a model to understand what happens when different choices are made by a ‘representative’ saver. A simple life cycle consumption model was created in which people live for two periods. At the start of each period, they make decisions about the allocation of their income against consumption to maximise the benefit from consumption in each period.

The model allows income to be timed to consumption forwards by saving or backwards by lending. Life-time income can change because consumers can cultivate their skills in the first period to improve their productivity and thus wages in the second period.

Exploring motives

Both rational and irrational motives for holding cash money were studied. The rational motive was assumed to arise from uncertainty caused by reasons external to the decisionmaker. The external uncertainty was assumed to blur the expected yield from illiquid savings and investment in education. In both cases, the worst scenario was that not only the interest but also the invested capital would vanish. In this context, saving cash money could provide a rational insurance against misfortunes.

As an irrational motive for saving cash, a factor internal to the decisionmaker was introduced, namely the psychological bias caused by money illusion.

A scenario was created where life-time income was fixed. The decisionmaker’s challenge was how to decide how much to save between the first and the second period. The decisionmaker had to decide how much of total savings to hold as liquid cash money and how much to hold as illiquid market deposits at a time when the market yield of the deposits was uncertain. Under these circumstances, it is rational to save cash as an insurance for future consumption according to the time preference.

The conclusion from this work was that holding more cash as insurance against uncertainty actually increased total savings compared to the saver who had perfect foresight and so didn’t hold cash as insurance. The rational insurance motive to save money increases total savings by replacing deposit savings more than one-to-one.

In addition, the share of cash depends on inflation and the share of deposit savings in total savings rises and falls in line with the expected market rate of return, the rate of interest. Higher anticipated inflation rates or higher expected interest rates mean a higher cost of holding one unit of money, and vice versa. Moreover, the calculus of compensating variation gives the implicit price that consumers are willing to pay for secured and, therefore, more satisfying consumption.

Cash holdings are higher if the rate of inflation is not fully anticipated. Lower inflation makes cash insurance, the feeling of security derived from holding cash, less expensive. If inflation is not properly known or anticipated, people may end up holding more cash than they need to.

Impact on education

The authors looked at what happened if investment in education was included. A lower than expected market interest rate would make the investment in education grow at the expense of deposit saving, and vice versa. People appeared willing to accept the ‘cost/benefit’ of holding cash and to invest in education.

The economists’ explanation of this is that since the yields from both education and deposit saving decisions are uncertain, the optimal amount of cash savings provides insurance for all kinds of negative surprises, including extreme outcomes such as total deposits completely vanishing and an inability to find a job that corresponds to the chosen education.

Impact of money illusion

Incorporating money illusion, which is a misjudgement of the inflation rate that makes consumers save excessively in cash at the cost of market deposit, means that the individual underestimates the cost of holding money and ends up over covering insurance against external uncertainty.

Total savings are smaller under money illusion than under perfect foresight, while the share of cash of total savings is larger.

Money illusion increases the cost of using cash as insurance. The extra cost equals the discounted opportunity cost of the overly saved amount of money. In general, the effect of the money illusion becomes the costlier the broader the deviance from the true inflation rate.

This finding shows that money illusion is a persistent feature in people’s behaviour with distortive consequences in the economy, particularly under creeping inflation.

Summary

This research finds that, while holding cash money can be a rational insurance against external uncertainties, human psychology can cause people to hold excessive cash savings. If a central bank wants to reduce cash holdings, the conclusions of this paper may be useful.

1 - Economic Working Paper 135, ‘Cash Money as a Saving Mode’. Hannu Laurila. Tampere University.