The opportunity cost of holding money is the cost that could be realized if money were invested instead of held. In other words, it is the interest rate that money is earning in a chosen investment. Typically, it is the interest rate that is set on a bond, particularly a government bond. Given the other investment choices that could be made, this cost could be very different from one person or entity to another.
To determine the true opportunity cost of holding money, it is necessary to first determine what the investment vehicle would have been. After that, 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 annually would be the opportunity cost of holding onto the money. Assigning a definite value would require first knowing how much money was being held, and how long it would be held for.
In economics, investing and holding money are known as mutually exclusive choices. This means that both cannot be done at the same time with the same money. If the money is being invested, it cannot be held. It may be possible for an individual to change his or her mind concerning the best choice for that money, but both strategies are not done simultaneously.
While most businesses and individuals may feel as though they would rather have their money working for them instead of simply being held, there could be valid reasons for not investing. Holding onto money gives businesses a certain amount of economic freedom because funds remain relatively liquid. This allows a business to make quick decisions with at least some of the funds it has at its disposal. Holding money, also tends to incur less risk than investing it, as well. These business choices will be different from one business to the next, depending on the goals.
An opportunity cost of holding money is also considered to be an explicit cost. This means that it is cost that is lost because of a lack of use by a company's own resources, in this case money. Explicit costs are contrasted with implicit costs, the latter of which are 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 look at many different factors. For example, if the business could act on a product or purchase that would enable it to make a better return on investment than current interest rates, it would be better to hold onto the money. Determining the best strategy often means anticipating and measuring all explicit costs.
