University of Dhaka

Department of International Business

Midterm Examination 1
Course Code: IB-207

Prepared by:
Md. Sakib Hossain
ID No. SM-030-113
Section: B
Department of International Business
University of Dhaka

Supervisor:
Dr. Mohammad Monirul Islam
Assistant Professor
Department of International Business
University of Dhaka

Date of submission: January 9, 2021

1. Explain how each of the following events affects the monetary base, the money multiplier,
and the money supply and explain in brief.

a. The Federal Reserve buys bonds in an open market operation.

b. The Fed increases the interest rate it pays banks for holding reserves.
c. The Fed reduces its lending to banks through its Term Auction Facility.
d. Rumors about a computer virus attack on ATM machines increase the amount of money
people hold as currency rather than demand deposits.
e. The Fed flies a helicopter over 5th Avenue in New York City and drops newly printed
$100 bills.

Answer: The monetary base B is the total number of dollars held by the public as currency C
and by the banks, as reserves R. The money multiplier is denoted by m, which is the factor
proportionality, (cr+1)/(cr+rr). It is the link between the monetary base and the money supply.
How the given events affect the money supply, monetary base, and the money multiplier is
explained in details below:

a. When the Fed buys bonds, the dollars that it pays to the public for the bonds increases the
monetary base. (The primary way in which the Fed controls the supply of money is through
open-market operations—the purchase and sale of government bonds. When the Fed wants to
increase the money supply, it uses some of the dollars it has to buy government bonds from the
public, vice versa)

Monetary base: B = C + R, increase in C means increase in B.

The money supply is the quantity of money available in an economy.

Money supply: M = C + D increase in C => Increase in M.

Monetary multiplier: m = (cr +1)/(cr+rr). The money multiplier is not affected, assuming no
change in the reserve-deposit ratio or the currency-deposit ratio.

b. When the Fed increases the interest rate it pays banks for holding reserves, this gives banks
an incentive to hold more reserves relative to deposits. By this, it influences the economy. The
increase in the reserve deposit ratio will decrease the money multiplier. The decline in the
money multiplier will lead to a decrease in the money supply. Since, banks are holding more
reserves (because they are making fewer loans), the monetary base will increase.
Increase in rr => decrease m=(cr+1)/(cr+rr)

M = mB, so when m decreases, M decreases.

c. If the Fed reduces its lending to banks through the Term Auction Facility, then the liquidity
in the US credit market increases. This results in a decrease in the monetary base, and this in
turn will decrease the money supply. The money multiplier is not affected, assuming no change
in the reserve-deposit ratio or the currency-deposit ratio.

d. If consumers lose confidence in ATMs and prefer to hold more cash, then the currency-
deposit ratio will increase, and this will reduce the money multiplier.

m = (cr+1)/(cr+rr), decrease in cr => decrease in m (rr are holding constant)

The money supply will fall because banks have fewer reserves to lend.

The monetary base will increase because people are holding more currency, but will decrease
because banks are holding fewer reserves. The net effect on the monetary base is zero.

e. If the Fed drops newly minted $100 bills from a helicopter, then this will increase the
monetary base and the money supply. If any of the currency ends up in the bank, then there
will be a further increase in the money supply. If people end up holding more currency relative
to deposits, then the money multiplier would fall.

2. Consider whether each of the following events is likely to increase or decrease real GDP. In
each case, do you think the well-being of the average person in society most likely changes in
the same direction as real GDP? Why or why not?

a. A hurricane in Florida forces Disney World to shut down for a month.

b. The discovery of a new, easy-to-grow strain of wheat increases farm harvests.
c. Increased hostility between unions and management sparks a rash of strikes.
d. Firms throughout the economy experience falling demand, causing them to lay off
workers.
e. Congress passes new environmental laws that prohibit firms from using production
methods that emit large quantities of pollution.

Answer:
 a. Service by Disney Land is interrupted after shutting down of facility for a few days. It
means now Disney does not create service. Thus, it negatively affects the Real GDP of
the country. It also leads to a decrease in the well-being of people. People lose their
jobs and do not have the income to spend.
b. It increases the more production of crops with the same level of inputs. Thus, the real
GDP of the country increases. It also leads to an increase in the well-being of people.
c. Fewer workers mean lesser production in the firm. It reduces the Real GDP of the
country and the well-being of people also get reduced.
d. Layoff induced by the falling demand implies the lesser production in the country.
Thus, real GDP falls and the income of workers falls as well. In this way, well-being
also suffers negatively.
e. It causes output to fall due to restrictions to items that emit pollution. It will improve
the quality of air. Hence it may be difficult to say if it will increase or decrease the well-
being of people. It will depend on people's preferences for environmental goods.

3. Suppose a woman marries her butler. After they are married, her husband continues to wait
on her as before, and she continues to support him as before (but as a husband rather than as
an employee). How does the marriage affect GDP? How do you think it should affect GDP?

Answer: There would be the filing of taxes in a joint manner rather than two single filers.
Thus, the GDP would be reduced by one taxpayer and a supported income of two. GDP will
be decreased by the number of butler's wages. Paid wages for household work are included in
GDP, but unpaid work is not. This understates GDP according to most economists, if there was
an easy way to calculate the cumulative value of such work it would be included.