The nominal interest reate and the demand for money

Question 1

Why is the nominal interest rate considered the cost of holding money?

Answer 1

Because it represents the interest you forgo by holding money instead of earning interest on savings or bonds.

Question 2

What do you give up when you hold cash instead of assets?

Answer 2

The opportunity to earn interest — the nominal interest rate.

Question 3

How does inflation affect the real return on money?

Answer 3

It causes the real value of money to fall, making the return on holding money negative.

Question 4

What is the real return on money if expected inflation is 5%?

Answer 4

−5%

Question 5

What is the formula for the cost of holding money using real return and inflation?

Answer 5

r−(−Eπ)=i

The cost of holding money equals the nominal interest rate.

Question 6

What is the general money demand function?

Answer 6

M/P=L(i,Y)

Question 7

In the function L(i,Y)L(i,Y), what does ii represent?

Answer 7

The nominal interest rate, which has an inverse relationship with money demand.

Question 8

In the function L(i,Y) what does Y represent?

Answer 8

Real income, which has a positive relationship with money demand.

Question 9

What happens to the demand for money when nominal interest rates rise?

Answer 9

It decreases, because the opportunity cost of holding money is higher.