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Economics 304 -- Homework - Lesson 11 -- 80 points

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1. a) (20 points) 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.

Business cycle can happen due to many

reasons. Let us say that there is a fall in
the consumer confidence due to an
external factor. This will reduce
consumption and hence AD would fall
and shift to the left. With this fall in
AD, there is a fall in labor demand as
well as when there is lesser demand
then firms also produce less.
Fall in labor demand implies that labor
demand or MPN curve shifts left and
hence they intersect to give a lower
employment.

Lower N implies a lower output. Hence

we come to point B. When there is a
fall in Y, there is also a fall in real wage
and therefore real wage is pro cyclical.
The average labor productivity at B is
higher than that of A. as the straight
line from origin to production function
is much steeper. This implies that
average labor productivity is actually
counter cyclical.
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b) (20 points) 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.

Efficiency wage or the real wage is sticky which means that there are some people
who would rather be unemployed than work at a lower wage. This does not allow the
market to clear like it would in classical economics. This real wage is perfectly rigid
till the effort function changes. As we can see in the labor market diagram, the real
wage is determining the employment and it is not impacted by labor supply at all.
This implies that any changes in effort are the other reason for wage to change.

When there is a great recession then people have lost wealth and their income from
other sources has fallen then the effort function itself changes. If we do not consider
the effort function then we say that during recession labor supply increases and this
increase in labor supply has no impact on either the real wage or the employment.
Hence for real wage to change, the effort function to change. The effort increases as
people want to work harder to ensure that they don’t lose their jobs and this change in
the effort function also reduces the real wage. Hence when there is a recession the
real wage falls making real wage pro-cyclical as per Keynesian economics.

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c) (20 points) 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.

The loss of wealth would have resulted in

the loss of consumption, hence shifting the
AD curve. Loss in wealth also implies that
more people are now willing to work and
hence the labor supply increases. The
increased labor supply reduces the real
wage. Hence real wag is pro cyclical. When
there is a recession then real wage also
falls.

d) (20 points) 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.

The loss in wealth implies that now more people are willing to work. But in efficiency wage
theory, labor supply has no impact on the real wage. Unless the effort function changes, the
real wage does not change. When there is a recession then people who are employed wants
to put in extra effort to ensure that they don’t lose their jobs and then their effort function
rises. This reduces their real wage. Hence in efficiency wage theory, unless there is a change
in effort there is no change in real wage. In recession, effort function increases leading to
fall in wage and making real wage procyclical. This is different than c as in c there is no
efficiency wage theory or effort function.