Question

Next year, in response to a truly massive boom in business optimism, the Japanese Central Bank is concerned about the economy. (14pts)
What kind of shock is Japan facing? _________________________________(positive or negative and supply or demand)?
If the Central Bank instead chooses to act, they can ___________________ (increase/decrease) interest rates, which ___________________ (raises/lowers) the price of bonds. If they do so, the money supply curve___________________ (moves left/moves right/is unchanged) while the money demand curve ______________________ (moves left/moves right/is unchanged). As a result of the central bank’s action outlined above, aggregate ___________________ (supply/demand) shifts ____________________ (leftward/rightward) and aggregate expenditure ___________________ (increases/decreases/stay the same) in the short run in response.
After this policy of the central bank takes effect, the price level/inflation ___________________ (increases/decreases/stays the same) and unemployment ___________________increases/decreases/stays the same) in the short run.
If the Central Bank does nothing, in the long run aggregate ___________________ (supply/demand) will shift ___________________ (insert direction) to restore equilibrium. In the long run, the price level will be ___________________ (higher/lower/unchanged) than if the central bank had intervened and GDP is ___________________ (at/below/above) full employment equilibrium.

Answer 1

The massive boom in business optimism, the Japanese central bank is concerned about the economy.

Here Japan is facing a positive demand shock.

If the central bank instead chooses to act, they can increase interest rates which raises the price of bonds. If they do so the money supply curve moves left while the money demand curve is unchanged. As the result of central bank's action outlined above, aggregate demand shifts leftwards and aggregate expenditure decreases in the short run in response.

After this policy of central bank takes effect, the price/inflation level decreases unemployment increases in the short run.

If the central bank does nothing, in the long run aggregate demand will shift leftwards to restore equilibrium. In the long run the price level will be higher than the central bank has intervened and GDP is at the full employment equilibrium.

Explanation. (This is completely optional if you are interested in whats really going behind the scene then you should read it)

The massive boom in business optimism leads to higher investment demand by businesses which is positive demand shock. So the concerned centarn bank of Japan if they chooses to tackle this situation must increase the interest rate in order to reduce the impact of boon in business optimism on investment demand. As a result of central bank's action will reduce the total money supply in the economy which will shift the money curve to leftwards while the money demand curve will remain unchanged. As a result of central bank's action the aggregate demand will get affected through investment demand and the aggregate demand shifts leftwards. And also as aggregate demand shifts left this lead to a decrease in aggregate expenditure. As result of central bank's action the price level will decrease due to reduced aggregate demand. And when aggregate demand decreases output level decreases and with that the unemployment rate goes up in short run.

If the central bank does in nothing, in the long run aggregate demand will shifts because if the boom in business optimism is not tackled this will result in excessive investment demand which will in turn lead to output level higher than full employment level. And once the output goes beyond full employment level the price level starts to increase on account of higher wages. And as price level increases real money balance in economy decreases (M/P) and as real money decreases the interest rates starts to increase and as result investment demand falls and aggregate demand shifts leftwards. And as already discussed the price level will be higher. And in the long run as Keynes said, 'we are all dead in the long run'. The output level in long run is always at the full employment level.

The important point to note is that if the central doesn't intervene the output level in the long run will still be at the full employment level but the price level will higher as compared to the case where central bank of Japan does chooses to intervene.