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Opportunity cost of holding money is the interest rate that could be earned if the money was invested instead. It varies depending on the investment vehicle and amount of money held. Holding money allows for economic freedom and less risk, but may not be the best strategy for every business. It is an explicit cost that must be weighed against potential returns.
The opportunity cost of holding money is the cost that could be realized if the money were invested rather than held. In other words, it is the interest rate money earns in a chosen investment. Typically, it is the interest rate set on a bond, especially a government bond. Given the other investment choices that might be made, this cost could be very different from one person or entity to another.
To determine the true opportunity cost of holding money, one must first determine what the investment vehicle would have been. Next, the next step is to research what the interest rate would be on that investment strategy. If the annual percentage rate is a single percent, then one percent would be the opportunity cost of holding the money. Assigning a definite value would first require knowing how much money was held and how long it will be held.
In economics, investing and holding money are known as mutually exclusive choices. This means that both cannot be run at the same time with the same money. If money is invested, it cannot be held. It might be possible for an individual to change his mind about the best choice for that money, but both strategies are not done simultaneously.
While most businesses and individuals may think they’d rather have their money working for them than simply being held, there may be compelling reasons not to invest. Withholding money gives businesses some economic freedom because funds remain relatively liquid. This allows a business to make quick decisions with at least some of the funds at its disposal. Even holding money tends to risk less than investing it. These business choices will differ from company to company, depending on your goals.
An opportunity cost of holding money is also considered an explicit cost. This means that it is a cost lost due to a lack of use of a company’s own resources, in this case money. Explicit costs are contrasted with implicit costs, the latter being intangible costs that are often very difficult to measure with a definite value.
When determining whether or not an opportunity cost of holding money is worth it, a business must consider many different factors. For example, if the company could act on a product or purchase that would give it a better return on investment than current interest rates, it would be better to keep the money. Determining the best strategy often means anticipating and measuring all explicit costs.
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