The central bank raises the nominal interest rate sharply. According to the three-motive theory of money demand, what should happen to speculative money demand?
AIt rises, because higher interest rates signal economic strength and encourage holding liquid assets
BIt falls, because higher current rates make bonds more attractive than holding cash, reducing the incentive to hold money speculatively
CIt stays the same, because speculative demand depends only on income, not interest rates
DIt rises, because agents need more liquidity to service higher-interest debt obligations
Speculative money demand is inversely related to the interest rate. When rates are high, bonds offer attractive yields — so agents prefer bonds over cash. When current rates are high, they are also more likely to fall in the future, meaning bond prices will rise, offering capital gains for bond holders. Both effects push speculative money demand down. Options C and D confuse speculative demand with other motives: transactions and precautionary demand primarily respond to income.
Question 2 Multiple Choice
A severe recession reduces national income and output. What happens to aggregate money demand according to the money demand function L(Y, i)?
AMoney demand rises — people hoard cash when the economy is uncertain
BMoney demand rises — lower income means people need more liquidity to meet basic expenses
CMoney demand falls — lower output means fewer transactions and smaller precautionary reserves, shrinking both the transactions and precautionary motives
DMoney demand is unchanged — only interest rate changes affect money demand
The money demand function L(Y, i) is increasing in real output Y. In a recession, Y falls — fewer goods are being produced and exchanged, so there is less need to hold transaction balances. Lower incomes also reduce precautionary reserves (smaller expected unexpected expenses). The result is a leftward shift in money demand. Option A describes an informal behavioral tendency not captured in the core Keynesian three-motive framework.
Question 3 True / False
Holding money has an opportunity cost equal to the interest foregone by not investing in interest-bearing assets like bonds.
TTrue
FFalse
Answer: True
This is the foundational premise of money demand theory. If you hold $10,000 in cash when bonds yield 5%, you forgo $500 per year. This opportunity cost is what makes money demand an interesting economic puzzle: why hold money at all? The three motives — transactions, precautionary, and speculative — each identify what money can do that bonds cannot (facilitate exchange instantly, provide perfect liquidity), justifying its demand despite the cost.
Question 4 True / False
The speculative motive for holding money increases when interest rates are high, because agents want to take advantage of the high returns available in the economy.
TTrue
FFalse
Answer: False
This reverses the relationship. Money itself pays no interest — the speculative motive concerns the choice between holding money versus holding bonds. When interest rates are high, bonds offer high yields and are therefore attractive. Agents shift from money into bonds, reducing speculative money demand. Speculative demand is high when rates are LOW (or expected to rise, making bonds risky) and low when rates are HIGH. Confusing 'high rates in the economy' with 'money generates high returns' is a common error.
Question 5 Short Answer
Why do the transactions and precautionary motives for money demand both increase with income, while the speculative motive responds to the interest rate instead?
Think about your answer, then reveal below.
Model answer: Transactions and precautionary demands scale with the volume of exchange and the size of potential unexpected expenses — both of which grow proportionally with income. The speculative motive is a portfolio decision: how much wealth to hold in money versus bonds. This choice depends on the relative return of bonds (the interest rate) and expectations about future rate changes, not on income.
The key distinction is what each motive responds to. Transactions and precautionary demands are driven by the need for liquidity in proportion to economic activity — income scales this need. Speculative demand is driven by portfolio optimization — the tradeoff between money's perfect liquidity and bonds' yield. These are fundamentally different economic forces, which is why the aggregate money demand function L(Y, i) must include both income and the interest rate as separate arguments.