Empirical studies indicate that the velocity of money tends to increase when interest rates rise. Which of the following best explains why this is true?
A) When the velocity of money is high, banks will increase their lending interest rates.
B) An increase in the growth rate of GDP will cause the velocity of money to increase.
C) The higher interest rates increase the cost of holding money balances and, thereby, increase the velocity of money.
D) Both the velocity of money and interest rates will rise when the inflation rate falls.

Question

Quizplus · Accepted Answer

The higher interest rates increase the cost of holding money balances and, thereby, encourage individuals and businesses to spend money, which increases the velocity of money. This is because people would rather invest or spend their money rather than hold onto it if the cost of keeping it, in terms of lost potential interest or the opportunity cost of not investing, is higher.

Empirical Studies Indicate That the Velocity of Money Tends to Increase