a) A business cycle fact is that real wages are pro-cyclical. Using the classical labor market as we have all semester, show and explain how the classical economists explained this business cycle fact. In your essay, be sure to draw and refer to a completely labeled labor market diagram and production function showing exactly how the classical economists explain this business cycle fact. In particular, start at an initial equilibrium labeled as point A and then move to the new equilibrium as point B, clearly labeling the relevant 'shift' variables. Finish your essay by addressing the cyclicality of average labor productivity from point A to point B. Be sure to identify average labor productivity in your graph of the production function.
b) The New Keynesians have their own 'story' as to why real wages are pro-cyclical. In the space below, write an essay explaining how the New Keynesians explained this business cycle fact. In your essay, be sure to identify exactly how the real wage is determined using the efficiency wage theory. Draw and refer to a graph of the effort function along with a labor market diagram assuming, as usual, that the efficiency wage is greater than the wage that would otherwise clear the labor market. Finish your essay by showing, using only your effort function diagram (and not your labor market diagram), how a pro-cyclical real wage can be explained by the efficiency wage theory.
c) We know that during the Great Recession, about $14 trillion in wealth was lost with half being a loss in stock market wealth and the remainder being a loss in real estate wealth. Focusing only on the impact of this loss of wealth on labor supply, use the classical model and comment the implications as to the cyclicality of the real wage. Be sure to use a labor market diagram to support your answer.
d) Given the same shock to wealth (a loss of $14 trilion), use the efficiency wage theory to comment on the cyclicality of the real wage. Be sure to use an effort function diagram to support your answer. Is your answer similar or different relative to your answer in part c)? Explain.