How does a rise in interest rates affect the demand for real money balances, assuming other factors remain constant ?
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Answer: A. fall
Explanation
Higher interest rates increase the opportunity cost of holding non-interest-bearing cash balances. Rational individuals reduce their holdings of real money as borrowing costs rise. The demand curve for real money balances slopes downward in response to interest rates. Real money balances represent nominal money divided by the aggregate price level. Liquidity preference theory explains how interest rates govern cash holding decisions. Alternative assets like bonds become more attractive when interest rates increase.
Central banks use interest rate adjustments to influence money demand and economic activity. Financial markets react immediately when monetary policy alters the cost of capital. Understanding money demand is essential for effective macroeconomic stabilization policy. An increase in money demand contradicts the basic opportunity cost principle. Assuming no change ignores the fundamental relationship between interest and liquidity. None of these is incorrect because the first option accurately states the outcome.
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