Money as Insurance

Abstract

Liquid money controlled by a trustworthy central bank can serve as an insurance against external surprises such as stock market crashes, bank fails and other setbacks that endanger the yield of illiquid savings. In turbulent times, the insurance property of money is particularly accentuated. The paper constructs a life cycle framework for the analysis of rational and irrational motives to save money, answers to questions about the effects of saving liquid money on labor supply, illiquid saving and education, and examines the inherent cost of saving cash. The main findings are the following. The rational insurance motive to save money increases total savings by replacing deposit saving more than one-to-one. The share of deposit savings depends positively on the expected interest rate, while the share of cash savings is the higher the less there is inflation. Deposit saving correlates positively and education negatively with the expected market interest rate thus affecting the relative proportion of liquid and illiquid saving, but the implicit cost of cash insurance is independent of education. Money illusion adds an internal bias to consumers’ life-time optimization, thus making them save excessively in cash at the cost of market deposits and increasing the cost of using cash as insurance against external uncertainty.