Question

1. Assume that workers became fearful of job security and the aggregate demand curve shifted to the left.
   1. Explain how neo-classical economists would address this situation in general.
   2. Identify the 3 major tools of monetary policy and explain how each of these tools would be used to correct this situation.

Answer 1

Neo-classical economists will address the situation, while considering wages are flexible in nature. Due to wage flexibility, workers will be ready to work at a lower wage if they get employed. It means that wage rate decreases also supported by the behavioral tendencies of the workers with increase in the supply of workers in the labor market. It causes cost of production to decreases and aggregate supply increases. It makes correction in the economy on its own and economy achieves long run equilibrium again.

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The first tool is open market operation. This is the tool, used to buy or sell government securities from the open market to either inject or suck the money out of the economy. In the given scenario, open market operation will be used to increase the money supply by buying the government securities from the market. It will increase consumption and investment spending to stimulate aggregate demand and AD curve shifts to the right.

The second tool is federal fund rate or interest rate. In the given scenario, the interest rate ( or federal fund rate in the USA) will be decreased. It will cause other key rates to decrease as well and cost of borrowing decreases. It also stimulates spending and AD increases. It makes AD curve to shift to the right and help economy recover.

The third tool is modifying the reserve requirements. In the given scenario, reserve requirements will be lowered so that banks have more funds for lending. It increases spending and investment. As a result, aggregate demand increases and shifts to the right. It helps economy to grow again.