The New-Keynesians came up with their own story as to why we observe the positive money - output correlation. Begin with discussing why the New Keynesians believe that prices are sticky in as much detail as possible. Then use the efficiency wage theory/model to buttress (support) your argument (i.e., why does the efficiency wage theory play a critical role in explaining why firms are willing to produce more output at the same price?). Draw two graphs, one showing the effort curve and the efficiency wage (be sure to explain how firms pick the efficiency wage) and the other being a labor supply labor demand diagram with the assumption that the efficiency wage (w*) is above the market clearing (classical) wage (wclass). Why is this model so attractive in dealing with the empirical reality in labor markets that the classical school has such a hard time with? Now draw another diagram depicting what is happening in the product markets (assume monopolistic competition) and why firms are willing to change output at the given price level (short run) given the change in the money stock. Be clear (in words referring to your diagram) as to why exactly firms are willing to act like a 'vending machine' in the short run (increase output at the same price). Is this firm behavior, being willing to increase output at the same price, consistent with the firm's profit maximizing objective? Why or why not? Explain.
