Quiz 14: Modern Macroeconomics and Monetary Policy


People hold money for variety of reasons. 1. They hold money to make purchases of various daily use goods like milk, bead etc. 2. They hold money to buy gasoline or pay utility bills. 3. They hold money to pay for house rent. 4. They also hold money for unexpected happenings like accidents or medical emergency. An increase in the interest rate decreases the amount of money that people will want to hold because as interest rate increases opportunity cost of holding money also increases and this prompts the general public to keep less money in hand and more in their interest - earning accounts so that they benefit from high interest rates in terms of more interest income.

(a) This will decrease the quantity of money we want to hold because we want to have more money in our bank account rather than in our hand so as to earn more interest as interest rate on checking deposits have increased. (b) This will increase the quantity of money we want to hold because an increase in the expected rate of inflation means that prices are expected to rise at faster rate which means that we need more amount of money to make purchases and thus would want to hold more money. (c) When income of a person increases, his holding of all assets increases. Moreover, with increase in income, person wants to hold more money so as to make more purchases. So, increase in income will increase the amount of money we want to hold. (d) As differential interest rate between money market mutual funds and checking deposit increases, we would be transferring more funds from our checking deposit account to our money mutual fund account but there will be no impact on the money that we want to hold. Thus, this action will not influence the quantity of money we want to hold.

(a) The opportunity cost of obtaining a $100,000 house is the foregone interest if we have deposited the same amount in bank or have invested it in bonds. (b) The opportunity cost of holding a $100,000 house for one year is that we would not be able to utilize the same amount for investment elsewhere and have to forgo the good investment opportunities for whole one year. Secondly, we would be having $100,000 less to spend on purchase of goods and services. (c) The opportunity cost of obtaining $1,000 is the loss of interest that we would have earned if these $1,000 have been kept in our interest-earning checking account. (d) The opportunity cost of holding the $1,000 in our checking account for one year is availability of less money for purchase of goods and services. In other words, putting these $1,000 in bank means that we would have $1,000 less to spend on goods and services and thus would be consuming less. Thus, opportunity cost of holding $1,000 in our bank account is less consumption.

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