The money demand curve is downward sloping because
A the transaction demand for money decreases as interest rates fall
B) people hold less money as the opportunity cost of holding money rises C) money is less liquid as interest rates rise, so people are able to hold less of it
D) banks are more willing to create money when interest rates fall
E) with higher incomes, people are willing to hold smaller percentages of their money
The Correct Answer and Explanation is :
The correct answer is:
B) People hold less money as the opportunity cost of holding money rises.
Explanation:
The money demand curve is downward sloping because of the inverse relationship between interest rates and the quantity of money demanded. This relationship exists because interest rates represent the opportunity cost of holding money.
- Opportunity Cost of Holding Money
- When individuals and businesses choose to hold money (instead of investing or saving it in interest-bearing assets like bonds or savings accounts), they forgo the potential interest income they could earn.
- As interest rates rise, this opportunity cost increases, making people less willing to hold large amounts of money in liquid form. Instead, they convert it into interest-bearing assets, reducing the quantity of money demanded.
- Liquidity Preference Theory
- This concept, introduced by John Maynard Keynes, explains that money is held primarily for transactions, precautionary, and speculative purposes.
- When interest rates are high, the speculative demand for money decreases since people prefer to invest in bonds or other financial instruments that yield returns.
- Impact of Falling Interest Rates
- Conversely, when interest rates fall, holding money becomes less costly since the return on alternative assets is lower.
- This leads to an increase in money demand as individuals and businesses prefer liquidity over investing in low-yield assets.
- Why Other Options Are Incorrect
- A) The transaction demand for money actually increases when interest rates fall because economic activity tends to rise.
- C) Money remains equally liquid regardless of interest rate changes.
- D) Banks may lend more, but that affects money supply, not demand.
- E) Income levels influence money demand but do not directly explain its downward slope.
Thus, option B best explains why the money demand curve slopes downward.
Here is the conceptual illustration of the money demand curve, showing the downward-sloping relationship between interest rates and the quantity of money demanded. Let me know if you need any modifications or explanations!