Suppose you\'ve just Inherited $10,000 from a relative. You\'re trying to decide

Question

Suppose you've just Inherited $10,000 from a relative. You're trying to decide whether to put the $10,000 In a non-Interest-bearing checking account so that you can use It whenever you want (that Is, hold It as money), or to use It to buy a u.s. Treasury bond. Suppose the Interest rate on the bond Is 5% per year. What would be the opportunity cost of holding the $10,000 as money? Now, suppose that the Interest rate fell to 1% per year. This would cause the opportunity cost of holding the $10,000 as money to to per year. What does the previous analysis suggest about the market for money The quantity of money demanded Increases as the Interest rate falls. The supply of money Is Independent of the Interest rate. The quantity of money demanded decreases as the Interest rate falls.

Explanation / Answer

The opportunity cost (as in money lost) of holding on to the money would be $500 per year. If interest fell to 1% per year, the opportunity cost of holding on would FALL to $100 per year. This shows that the quantity of money demanded increases as the interest rate falls, because the opportunity cost of holding onto that money falls. Hope this helps!

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