Suppose a Family Is Holding $1000 in Its Checking Account

question 103

Multiple Choice

Suppose a family is holding $1000 in its checking account for normal transactions, $500 in cash for emergencies, and $1500 as a store of value when the interest rate is 4 percent. If the interest rate rises to 10 percent, which of the following patterns of holding money would be most likely and why?

• A) Transactions demand-$1000; Precautionary demand-$350; Asset demand-$500, because the opportunity cost of holding money has increased. The reduction money balances held as an asset is greatest because interest-bearing assets are much more attractive when interest rates are higher.
• B) Transactions demand-$500; Precautionary demand-$500; Asset demand-$1400, because the opportunity cost of holding money balances has risen. The reduction in money balances held for transaction purposes falls the most because people start using credit cards more when the opportunity cost of holding money increases.
• C) Transactions demand-$1000; Precautionary demand-$500; Asset demand-$500, because only the asset demand is responsive to changes in the interest rate.
• D) Transactions demand-$800; Precautionary demand-$600; Asset demand-$1500, because people can economize on their money balances for making transactions, but the possibility of an emergency increases with the interest rate. People will also expect rates to go higher, so they will hold money as an asset until the rates increase further.

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Definitions:

Opportunity Cost

Losing the benefits of the closest substitute when a choice is made.

Tablet Computer

A portable personal computer equipped with a touchscreen as the primary input device, designed for mobility and convenience.

Economics Textbook

A publication that systematically presents economic theories, principles, and concepts to learners at various levels of education.

Opportunity Cost

Abandoning the possibility of gains from alternative options by selecting one choice.