Liquidity Preference
The Nine-Year-Old: Dad?
Me: Yes?
The Nine-Year-Old: I have forty-two dollars that I can spend that I have saved from my allowance.
Me: That's a lot. But what do you mean, "...that I can spend."
The Nine-Year-Old: Oh, I have forty-six more dollars that I can't spend.
Me: What do you mean? It's your money. You can spend it if you want.
The Nine-Year-Old: No I can't. Remember the pinball machine? The one I really wanted to get at Target? The one that cost fifty dollars?
Me: Yes...
The Nine-Year-Old: I've enjoyed it more than any other toy. And the only reason I could get it was because I had all this money that I couldn't spend.
Me: But you did spend it.
The Nine-Year-Old: Dad! Don't be silly! I mean that I have forty-six more dollars that I can't spend unless I find something really expensive and really unusual that I really want right now.
Me: Ah. You mean you have a preference to hold forty-six dollars of your wealth in a liquid--that is, ready-to-spend--form.
The Nine-Year-Old: Exactly.
Me: And under normal circumstances having that money, and thus having the option to buy something you really like if you see it, is more valuable to you than anything you would normally use that money to buy.
The Nine-Year-Old: Yes.
Me: But why forty-six dollars?
The Nine-Year-Old: Because the pinball machine cost fifty. And you can always find four dollars hidden around someplace. And fifty minus four equals forty-six.
Me: There are other, more complicated ways to calculate the option value of holding so much of your wealth in cash.
The Nine-Year-Old: But my way works! I can subtrace four from fifty. I probably couldn't do the kinds of calculations you would do. Dad, I'm only in fourth grade!
Posted by DeLong at October 28, 2002 09:49 AM | Trackback