Sherman Peabody earns a monthly salary of $1,500, which he receives at the beginning of each month. He spends the entire amount each month at the rate of $50 per day. (Assume 30 days in a month.) The interest rate paid on bonds is 10 percent per month. It costs $4 every time Peabody sells a bond.

a. Describe briefly how Mr. Peabody should decide how much money to hold.

b. Calculate Peabody’s optimal money holdings. (Hint: It may help to formulate a table such as Table 26B.1 in this Appendix.

You can round to the nearest $0.50, and you need to consider only average money holdings of more than $100.)

c. Suppose the interest rate rises to 15 percent. Find Peabody’s optimal money holdings at this new interest rate. What will happen if the interest rate increases to 20 percent?

d. Graph your answers to

b. and

c. with the interest rate on the vertical axis and the amount of money demanded on the horizontal axis. Explain why your graph slopes downward.