JPSem

2)
If households are holding larger real money balances than they desire, which of the following is least likely?

A) The central bank must sell securities to absorb the excess money supply and establish equilibrium.
B) The interest rate is higher than its equilibrium rate in the market for real money balances.
C) The opportunity cost of holding money balances will decrease.

Your answer: B was incorrect. The correct answer was A) The central bank must sell securities to absorb the excess money supply and establish equilibrium.
If households’ real money balances are larger than they desire, the interest rate (opportunity cost of holding money balances) is higher than its equilibrium rate. Households will use their undesired excess cash to buy securities, bidding up securities prices and reducing the interest rate toward equilibrium. This market process does not require any action by the central bank.

Q: I attempted this question with the thinking that when household’s real money balances are larger than desire, it means that interest rate are not high enough to induce them to invest. Whats wrong with this approach?
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I understand it this way,....
if household hold excess cash balances in their accouunt, he reason could be

A) say Interest given by banks is 5%, but the market expectation is say 7%...so you would not invest money in the bank that gives less than the market expected return(oppurtunity cost)
. Hence the Interst rate in the market are higher then the equilibrium...
B) Households will invest this money in more lucrative use like, Equity/Real Estate and bid up the Securities prices and reduce the Interst rate....

This whole process occurs without the active interference of the Fed(central bank)