Question

QUESTION 1 0.5 poir The demand for money is mainly influenced by three variables: r (the short-term interest rate), Y (real GDP), and P (the aggregate Price level). Suppose r rises, but Y and P are unchanged. What happens to the quantity of money demanded? r is both the opportunity cost of holding money and the reward for holding bonds. Thus, an increase in r causes people to want to hold of their wealth in the form of money and 4in the form of bonds to take advantage of the higher interest rate.

Answer 1

The demand for money is mainly influenced by three variables:

1. r (the short-term interest rate)
2. Y (real GDP)
3. P (the aggregate price level)

Suppose r rises, with Y and P unchanged.

r is both the opportunity cost of holding money and the reward for holding bonds.

Thus, an increase in r causes people to want to hold less of their wealth in form of money and more in the form of bonds to take advantage of the higher interest rate.

This is because since r is the opportunity cost of holding money, people lose the opportunity to earn interest by holding money. High interest rates therefore imply a low liquidity preference because people are more likely to hold bonds and earn high interests rather than holding their wealth in form of money.