Savings exist in different forms, each of which produces different rates of return for saving agents. These agents economize on cash balances. Each person must decide how to allocate his or her wealth. It will be useful to hold some of this wealth in currency – what economists call outside or base money. Holding currency provides the benefit that cash can be converted to goods all but instantly. However, the holder of currency is provided no return in exchange for a decision to abstain from consumption. This person may find benefit from depositing a portion of wealth at a financial intermediary. For example, he or she may deposit this currency in a checking account at a bank. Most holders of checking accounts consider these to be as good as cash as they can draw from them on demand in order to make purchases. Banks can also offer payment of interest to holders of checking accounts as the bank lends out a significant portion of the funds deposited. The lower the cost of intermediation, the greater the rate of return that can be offered to savers, the lower the interest rate charged to borrowers, and the greater the portion of savings that can be used effectively by the system.
The rate of return for a particular form of saving is influenced by the cost of the form of saving. The cost of liquidity is a significant influence on interest paid to a saver. Checking accounts are highly liquid, practically as good as currency. They also pay a relatively low return compared to other financial instruments. Homes, on the other hand, are a less liquid form of wealth as a significant amount of time is required for completion of a sale of , or even a loan against, the asset. Much of the reduction of the costs of intermediation in recent decades have come in the form of decreased liquidity costs.
An increase in the availability of relatively liquid financial instruments allows investors to decrease their demand to hold currency. An ideal instrument for an investor provides a sizable rate of return and can very quickly be turned into money. Treasury bills, those promises by the government to repay loans of maturity of one year or less, have long served this purpose. The brevity to maturity and sureness of repayment – as long as the government is able to collect taxes, it is able to repay – makes treasury bills highly saleable. Much as with checking accounts, holders of government treasuries expect that they will be able to quickly access currency of the value of the bond if need be. Less liquid instruments – e.g., junk bonds – require a longer waiting period for the seller to find a buyer who is willing to pay the full price of the instrument. An inability to wait for this leads to a reduced sale price.
In this post, I have described the tradeoff between liquidity and rates of return. In my next post, I will consider the role liquidity plays in alleviating demand for base money, especially during a crisis.