Question

1. Why might the demand for money be affected by changes in interest rates?
                                                                                                                                       [8 marks]

Answer 1

Interest rate acts as the opportunity cost of holding money.

When the interest rate rises then opportunity cost of holding money increases.

As the opportunity cost of holding money increases, people hold less money and thus their demand for money decreases.

On the other hand, when the interest rate falls then opportunity cost of holding money decreases.

As the opportunity cost of holding money decreases, people hold more money and thus their deman for money increases.

So,

The change in interest rate by affecting the opportunity cost of holding money affects the demand for money.