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When explaining the time value of money (e.g. the fact that \$100 today is worth more than \$100 a year ahead), I have seen 3 arguments: impatience, risk and inflation. What about a fourth argument that I would call alternative opportunity cost:

  • I could invest the \$100 today and thus obtain more than \$100 a year later. I could do that practically risk free if I want to. That makes me value a given amount today higher than the same amount in the future.

Would that make sense, or is this perhaps already implied by one or more of the first three arguments?

Richard Hardy
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1 Answers1

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What you describe would be called an opportunity cost (or in this specific example opportunity cost of holding cash) in economics (see Mishkin & Eakins Financial Markets and Institutions pp 295).

However, the other factors are already overlap with the opportunity cost. As you say you could invest today and obtain more than \$100 a year later essentially risk free. But why? Well because sellers have to compensate people for their impatience & inflation even though the security is risk free.

So this 'alternative cost' or opportunity cost as we would call it in economics is not an additional exclusive factor, rather it covers together all hosts of other factors. In fact, some texts just dispense with listing factors such as impatience and just will directly say nominal interest rate is compensation for the opportunity cost of holding cash.

1muflon1
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  • Yes, of course, I messed up the terminology; I meant opportunity cost, not alternative cost :) Thanks for a great explanation! – Richard Hardy Sep 24 '22 at 15:42