Principle of Economics

Midterm Exam April 22, 2022

1. From the beginning of the fifteenth century, Europeans conquered and colonized many
other countries. However, countries that were colonized by Europe have marked differ-
ences in their economic development today. Among them, societies such as the Mughals
in India and the Aztecs and Incas in the Americas were among the richest civilizations
in 1500, but the countries that now exist within their borders today have very low per
capita national incomes. . By contrast, countries such as North America, New Zealand
and Australia, which were less civilized at the time, now have very high per capita
national incomes.

(a) (5%) Why are there such dramatic differences in the economic development of
countries colonized by Europe today? Explain your answer with reference to the
extractive or inclusive institutions.
(b) (5%) Can you use the geography hypothesis to explain the ”The Reversal of For-
tune” described above? Explain.

1
 Principle of Economics
Midterm Exam April 22, 2022

2. Explain how the equilibrium real interest rate and the equilibrium amount of credit
would change in each of the following scenarios.

(a) (5%) Assume a government provides a large tax credit for individuals who save
more money in banks.
(b) (5%) Assume a government implements large tax increases on business invest-
ments.
(c) (5%) A significant increase in the amount of government borrowing to issue shop-
ping voucher.

2
 Principle of Economics
Midterm Exam April 22, 2022

3. Suppose, the following is the balance sheet of a bank (in billions of dollars):

Assets Liabilities and Shareholders’ Equity

Cash $30 Demand Deposit $90
Long-term Investment A Total Liabilities $90
Shareholders’ Equity B
Total Assets $110 Liabilities & Equity C

(a) (4%) Please fill in the blanks A and B of the balance sheet above.
(b) (6%) Suppose the financial crisis causes banks to lose 10% of their long-term in-
vestments. Please complete items D, G and H in the balance sheet below according
to this scenario.

Assets Liabilities and Shareholders’ Equity

Cash $30 Demand Deposit F
Long-term Investment D Total Liabilities F
Shareholders’ Equity G
Total Assets E Liabilities & Equity H

(c) (5%) Now suppose there are rumors that the bank lost 30% of their long-term
investments, what would happen if the rumor was true?
(d) (7%) Suppose the bank clarified that the loss of long-term investment is 10% in-
stead of 30%. Why does this rumor could still trigger a bank run? Explaining this
phenomenon could be a self-fulfilling prophecy based on the behavior of individual
depositors and the structure of the bank’s balance sheet.
(e) (3%) How does the provision of deposit insurance reduce the likelihood of this
event described in part (d)?

3
 Principle of Economics
Midterm Exam April 22, 2022

4. Suppose an American worker can produce either 100 shirts or 30 computers a year,
while a Chinese worker can produce 100 shirts or 10 computers. The U.S. and China
have 10 workers and 15 workers, respectively.

(a) (6%) Graph the production possibilities curve for the two countries. Suppose that
in the absence of trade, workers in each country spend half their time producing
each good. Identify this point in your graph. (The x-axis is the number of shirts
and the y-axis is the number of computers)
(b) (4%) Please compute and explain what the slope of the production possibilities
curve for each country represents?
(c) (4%) Which country would export shirts if these countries were open to trade?
explain.
(d) (5%) Explain what price range the two countries can trade in computers (in terms
of shirts).
(e) (6%) Suppose the United States and China form an alliance for free trade and
decide to invite Australia, New Zealand, and Japan to join the alliance. The
per worker production information for these three countries is shown in the table
below. If the order in which the five countries decide to produce shirts is the
United States, Australia, Japan, New Zealand, and China, draw a production
possibility curve in this alliance.

workers Shirts (per worker) Computers (per worker)

Australia 5 80 15
New Zealand 3 80 10
Japan 10 120 20

(f) (5%) Is the PPC in part (e) the most efficient case? If so, please explain specifi-
cally; if not, please give the coalition advice on how to make these five countries
more productive and redraw the production possibility curve to compare it with
the PPC in part (e).

4
 Principle of Economics
Midterm Exam April 22, 2022

5. Kawmin is a small country that produces and consumes jelly beans. The world price
of jelly beans is $1 per bag, and Kawmin’s domestic demand and supply for jelly beans
are governed by the following equations, where P is in dollars per bag and Q is in bags
of jelly beans.

Demand of jelly beans: QD = 8 − P

Supply of jelly beans: QS = P

(a) (5%) Draw a well-labeled graph of the situation in Kawmin if the nation does
not allow trade. And calculate the following: the equilibrium price and quantity,
consumer surplus, producer surplus, and total surplus.
(b) (5%) Kawmin then opens the market to trade. Draw another graph to describe
the new situation in the jelly bean market. And calculate the equilibrium price,
quantities of consumption and production, imports, consumer surplus, producer
surplus, and total surplus.
(c) (5%) After a while, the Czar of Kawmin responds to the pleas of jelly bean pro-
ducers by placing a $1 per bag tariff on jelly bean imports. Show the effects of
this tariff on a graph and calculate the equilibrium price, quantities of consump-
tion and production, imports, consumer surplus, producer surplus, government
revenue, and total surplus.
(d) (5%) According to part (b), what are the gains from opening up trade? According
to part (c), what are the deadweight losses from restricting trade with the tariff?
Give numerical answers.

5
 Principle of Economics
Midterm Exam April 22, 2022

Suggested Solution
Problem 1

(a) The dramatic gap is due to the difference in adopted institutions. Europeans adopted
extractive institutions when occupied Central and South America, while they adopted
inclusive institutions when occupied North America and Australia. Five hundred years
ago, Central and South America were rich in natural resources that colonists could easily
profit from extracting. However, North America and Australia at the time did not have
so many minerals and labor that Europeans could only colonize through accommodating
inclusive institutions.
(b) No. If geography is the main reason for the difference in wealth among these countries,
those that were rich 500 years ago should also be rich now, and vice versa. However, we
have observed the reversal of fortune over the 500 years, which cannot be explained by
the geography hypothesis.

Problem 2

(a) Individuals have more incentives to save money in the back, which implies the supply of
credit market will shift to the right. Consequently, the equilibrium interest rate will be
lower while the equilibrium quantity of credit will increase.
(b) The high tax rate will reduce the willingness of firms to invest, that is, the demand for
credit in the market will decrease. Thus, the demand curve shifts to the left, lowering
the equilibrium interest rate and equilibrium quantity of credit.
(c) As government borrowing increases, there is a consequent increase in the demand for
credit. The credit demand curve shifts to the right, raising the equilibrium interest rate
and the equilibrium quantity of credit.

Problem 3

(a) A=$80, B=$20

(b) D=$72, G=$12, H=$102
(c) If the rumors was true: D=$56, E=$86. Stockholders’ equity goes to zero, and the bank
is insolvent, with assets valued less than liabilities.

6
 Principle of Economics
Midterm Exam April 22, 2022

(d) If most of the depositors trust the rumor, they may try to withdraw their deposits at
the same time. This initial panic may lead other depositors to withdraw before the
liquid assets are gone given first-come first-served. When faced with a large demand
for withdrawals, banks are running low on cash in reserve. Although banks have a large
number of long-term investments, the low liquidity assets cannot be realized immediately
(because banks convert high-liquid deposits into low-liquid long-term investments to earn
an interest rate spread). To satisfy the demand of withdrawers, banks had to sell their
illiquid assets in ”fire sales”, and incur even greater losses. A self-fulfilling prophecy
eventually leads to a bank run.

(e) The role of deposit insurance is to stabilize the financial system in the event of bank
failures by assuring depositors they will have immediate access to their insured funds
even if their bank fails, thereby reducing their incentive to make a ”run” on the bank.

Problem 4

(a) See diagram.

(b) The slope of P P CU = −0.3 and the slope of P P CC = −0.1. The slope represents the
opportunity cost (in terms of computer) of each country to produce a shirt.

(c) Since the opportunity of producing shirts in China is lower than that of the U.S, China
will produce shirts and trade for computers, that is, China will become the exporter of
shirts.

7
 Principle of Economics
Midterm Exam April 22, 2022

(d) The terms of trade must lie between the U.S. and China’s opportunity costs.
10/3 shirts per computer ≤ terms of trade ≤ 10 shirts per computer
0.1 computers per shirt ≤ terms of trade ≤ 0.3 computers per shirt
(e) See diagram.

(f) The PPC in part (e) is not the most efficient case. If we want to make the coalition more
productive then the order in which shirts be produced should be determined according to
the opportunity cost of these five countries. The efficient order in which the five countries
decide to produce shirts is China, New Zealand, Japan, Australia, and the United States.
Obviously, we can find that the new curve is outside the original one, which means the
new one is more efficient.

8
 Principle of Economics
Midterm Exam April 22, 2022

Problem 5

(a) P ∗ = 4, Q∗ = 4, CS = 8, P S = 8, T S = 16

(b) P ∗ = 1, Qc = 7, Qp = 1, import = 6, CS = 49/2, P S = 1/2, T S = 25

9
 Principle of Economics
Midterm Exam April 22, 2022

(c) P ∗ = 2, Qc = 6, Qp = 2, import = 4, CS = 18, P S = 2, GR = 4, T S = 24

(d) Compare (a) and (b): Gains from trade=9

Compare (b) and (c): deadweight loss=1

10