Chapter 10: Problem 355

Which interest rate-nominal or real-represents the opportunity cost of holding cash? Explain.

Short Answer

Expert verified

The real interest rate represents the opportunity cost of holding cash, as it takes into account the effects of inflation on the purchasing power of money. By not investing in an alternative asset that earns the real interest rate, individuals who hold cash are losing purchasing power over time due to inflation.

Step by step solution

Understand nominal and real interest rates

The nominal interest rate is the rate at which the value of an investment grows without considering the effects of inflation, while the real interest rate takes into account the erosion of purchasing power caused by inflation. The real interest rate is given by the formula: real interest rate = (1 + nominal interest rate) / (1 + inflation rate) - 1.

Identify the opportunity cost of holding cash

The opportunity cost of holding cash is the rate of return an individual could have earned by investing the cash in an alternative investment, such as a government bond or a savings account, instead of holding cash. In other words, it is the return that is forgone by not putting the money to better use.

Determine the interest rate that represents the opportunity cost

The real interest rate better represents the opportunity cost of holding cash than the nominal interest rate. This is because the real interest rate takes into account the effects of inflation on the purchasing power of money. When an individual holds cash, they are essentially losing purchasing power over time due to inflation. By investing the cash in an alternative investment that earns the real interest rate, the individual would maintain their purchasing power and potentially even increase it. The real interest rate shows the net gain or loss in purchasing power when investing in an alternative asset, rather than holding cash.