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 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.

The opportunity cost of holding the inheritance as money depends on the interest rate on the bond.

For each of the interest rates in the following table, compute the opportunity cost of holding the $10,000 as money.

Interest Rate on Government Bond Opportunity Cost (Percent) (Dollars per year) 3 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

Amount of interest foregone is the opportunity cost of holding money.

Case I - Interest rate is 6 percent

Amount of interest = $10,000 * 0.06 = $600

So,

When interest rate is 6%, the opportunity cost of holding money is $600.

Case II - Interest rate is 3 percent -

Amount of interest = $10,000 * 0.03 = $300

So,

When interest rate is 3%, the opportunity cost of holding money is $300.

Following is the complete table -

Interest rate on Government Bond

(Percent)

Opportunity Cost

(Dollars per year)

Quantity demanded of money depends on the opportunity cost of holding money.

As opportunity cost of holding money decreases, quantity demanded of money increases and vice-versa.

So,

The quantity of money demanded increases as the interest rate falls.

Hence, the correct answer is the option (1).

Interest rate on Government Bond

(Percent)

Opportunity Cost

(Dollars per year)

6 600 3 300

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