Previous Year Question

The rate of interest can be understood as the opportunity cost of holding money. When a person holds cash, that person forgoes the interest that could have been earned by investing in an interest-bearing financial asset.

The question assumes that the supply of money remains fixed. If money demand increases against this unchanged supply, an imbalance arises in the money market.

People may sell bonds or other interest-bearing assets to obtain the additional money balances they desire. This tends to reduce bond prices and increase their yields or interest rates. The interest rate rises until the demand for money again equals the available money supply.

The adjustment can be understood as follows:

• Money supply remains fixed.

• Demand for money increases.

• Money demand exceeds the existing supply at the initial interest rate.

• The opportunity cost of holding money, represented by the interest rate, rises.

• The higher interest rate moderates money demand and establishes a new equilibrium.

Option (a) is incorrect. An increase in money demand alone does not necessarily cause a fall in the general price level. Prices depend on several factors, including money supply, output, velocity of money and aggregate demand.

Option (c) is incorrect. With a fixed money supply, an increase in money demand raises rather than lowers the equilibrium interest rate. A lower interest rate would generally encourage greater money holding by reducing its opportunity cost.

Option (d) is incorrect. An increase in income and employment is not the direct or necessary consequence of the change described. On the contrary, a higher interest rate may restrain investment and other interest-sensitive expenditure.