How is the demand for money generally related to the interest rate?

How is the demand for money generally related to the interest rate?

• A. Positively related to the opportunity cost of holding money
• B. Downward sloping function of the interest rate
• C. Upward sloping function of the interest rate
• D. None of the above

Answer: (B)

The demand for money is generally considered to be a downward-sloping function of the interest rate. This relationship is based on the opportunity cost associated with holding money. When the interest rate is high, individuals and businesses prefer to invest their funds in interest-bearing assets rather than holding money, which does not earn interest. As the interest rate decreases, the opportunity cost of holding money lowers, making it more attractive to hold liquid cash for transactions or precautionary purposes. This inverse relationship illustrates that as interest rates fall, the quantity of money demanded increases because people are less disincentivized by the potential earnings they miss out on by not investing those funds elsewhere. Conversely, as interest rates rise, the incentive to hold money decreases, prompting a reduction in the quantity of money demanded. This downward slope captures the essence of how liquidity preference operates in response to changing interest rates.

The demand for money is generally considered to be a downward-sloping function of the interest rate. This relationship is based on the opportunity cost associated with holding money. When the interest rate is high, individuals and businesses prefer to invest their funds in interest-bearing assets rather than holding money, which does not earn interest. As the interest rate decreases, the opportunity cost of holding money lowers, making it more attractive to hold liquid cash for transactions or precautionary purposes.

This inverse relationship illustrates that as interest rates fall, the quantity of money demanded increases because people are less disincentivized by the potential earnings they miss out on by not investing those funds elsewhere. Conversely, as interest rates rise, the incentive to hold money decreases, prompting a reduction in the quantity of money demanded. This downward slope captures the essence of how liquidity preference operates in response to changing interest rates.