WE SAW IN Chapter 6 that if the rate of return on other assets is greater than that of fiat money, fiat money is not valued in these model economies. We observe, however, that fiat money is valued in many real economies where other assets have a greater rate of return than fiat money. Why do people choose to hold fiat money when many alternative assets appear to offer greater rates of return? Chapter 6 gave us one possible answer. Risky assets would have to display a risk premium for risk-averse individuals to be willing to hold them. In this chapter we consider the additional possibility that fiat money is valued because it is more liquid than alternative assets.

Our study of liquidity will lead us to a study of financial intermediation. It may be that a private entity can arrange to offer people a liquid substitute for fiat money. Why might it wish to do so? The difference in the rates of return of liquid and illiquid assets opens up an opportunity for profits through arbitrage – by borrowing at the low rate of return of money while investing at the high rate of return of the illiquid asset.

Money as a Liquid Asset

As we saw in Chapter 6, if fiat money and other assets were perfect substitutes, people would value only the asset with the greater rate of return. To explain why fiat money is valued despite offering a lower rate of return than other assets, it may help to note evidence that fiat money and capital are held for different motives.