RELATED CONCEPTS:BONDS |CROWDING OUT |INFLATION PRELIMINARY EFFECT |INTEREST LIQUIDITY EFFECT |PRECAUTION DEMAND FOR MONEY| SPECULATIVE DEMAND FOR MONEY |TRANSACTION DEMAND FOR MONEY |.
Why is the opportunity cost of holding money the interest rate that a bond pays?
- Because instead of holding money, people could hold bonds, which pay interest.
Why does the quantity of money people want to hold go up when the interest rate falls?
- At lower interest rates, bonds are less attractive, so people increase their money holdings.
How can a person reduce money holdings yet spend the same amount of money per period?
- The individual would have to hold more of other assets (such as money market funds, bonds, and stocks) and cash them in more frequently.
How does an excess supply of money lead to lower interest rates?
- People with an excess supply of money will try to increase their bond holdings, thereby increasing the demand for bonds. Bond prices will go up and interest rates will go down.
How does a lower interest rate increase investment spending?
- A lower interest rate makes more investment projects profitable, so total investment spending will go up.
Why does aggregate demand go up when interest rates fall?
- A lower interest rate increases investment spending, so aggregate demand will be higher.
Is it the nominal interest rate or the real interest rate that affects money demand? Investment spending?
- The basic rule is: Nominal assets (such as money) are affected by the nominal interest rate, and real assets (such as investment in plant and equipment) are affected by real interest rates.
Why is the horizontal shift in aggregate demand greater than the equilibrium increase in real GNP?
- A shift to the right in aggregate demand causes prices to go up. So while total dollar spending has gone up, the higher price level means that real spending (and real GNP) have gone up less.
When will an increase in the money supply cause higher, not lower, interest rates?
- When people expect a higher growth rate of the money supply to produce higher rates of inflation.
Why is the spending multiplier weaker when we consider the effects of higher real income on money demand?
- Because people want to put some of their higher income into money holdings. This reduces the savings available for investment spending, and therefore investment spending will fall. In turn, this offsets to some degree the initial increase in aggregate demand.
Copyright 2008 by Sujanto Rusli
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