Which of the following events increases the opportunity cost of holding money?
A a rise in the nominal interest rate
B a decrease in consumers’ income
C an increase in the purchasing power of money
D an increase in consumers’ income
E a fall in the prices of goods and services
The correct answer and explanation is:
The correct answer is A: a rise in the nominal interest rate.
Explanation:
Opportunity cost refers to the value of the next best alternative that is forgone when a decision is made. When it comes to holding money, the opportunity cost involves not earning interest or returns on that money. The opportunity cost of holding money increases when there are better alternatives available, such as interest-bearing assets.
A rise in the nominal interest rate increases the opportunity cost of holding money because when interest rates rise, individuals and businesses can earn higher returns on their savings and investments. Holding money in cash or non-interest-bearing forms means losing out on the potential income from interest-bearing assets. Therefore, the higher the interest rate, the more attractive it becomes to invest rather than hold cash, making the opportunity cost of holding money higher.
On the other hand, the other options do not directly increase the opportunity cost of holding money:
- B: A decrease in consumers’ income could lead to less money being held in the economy as people spend more and save less. However, this does not directly affect the opportunity cost of holding money because income levels do not directly impact interest rates or the potential returns from investments.
- C: An increase in the purchasing power of money actually reduces the opportunity cost of holding money because individuals can buy more with the same amount of money. As a result, they are less inclined to seek alternatives for their cash holdings.
- D: An increase in consumers’ income might increase the demand for money, but it does not necessarily affect the opportunity cost directly since interest rates are still the primary determinant of opportunity cost for holding money.
- E: A fall in the prices of goods and services can lower the need for holding large amounts of money, but it does not directly impact the interest rate or the returns on holding money.
Therefore, a rise in the nominal interest rate increases the opportunity cost of holding money because it makes alternative forms of saving more attractive.