a) (20 points) The New Keynesians have their own 'story' as to why real wages are pro-cyclical. In the space below, explaining how the New Keynesians explained this business cycle fact. 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. 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.

b)(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.

c) (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 b)? Explain.