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)
8
10
What does the previous analysis suggest about the market for money?
The quantity of money demanded decreases as the interest rate rises.
The supply of money is independent of the interest rate.
The quantity of money demanded increases as the interest rate rises.
The correct answer is: The quantity of money demanded decreases as the interest rate rises.
This is because when the interest rate on government bonds is higher, the opportunity cost of holding money (not earning interest) increases. As a result, individuals and investors will be more inclined to invest in the higher yielding bond rather than hold money. Thus, the demand for money decreases as the interest rate rises.