Provide an economic explanation of what you have shown in your diagrams above. Discuss what happens to Iceland's (1) level of economic output, (2) employment, (3) real wage rate, and (4) real rental cost of capital. Be sure to explain why this takes place.
A major financial crisis is a supply shock, a decrease in total factor productivity from A0 to A1. This can be represented by a downward rotation of the production function from Y = A0*F(K0, L) to Y = A1*F(K0, L).
As a result of the downward rotation of the production function from Y = A0*F(K0, L) to Y = A1*F(K0, L) the slope of the production function, which is the marginal product of labor, has declined. A decline in the marginal product of labor is also a decrease in the demand for labor at any given real wage rate. This can be represented by a leftward shift of the demand for labor curve from LD0 to LD1.
The major financial crisis also led to a sharp decline in expected future income. As a result of the decline in expected future income the supply of labor would increase for any given real wage rate. This can be represented by a rightward shift of the supply of labor curve from LS0 to LS1.
As a result of the decrease in the demand for labor and the increase in the supply of labor, the real wage will fall. Labor market equilibrium will be re-established at the intersection of the supply of labor curve, LS1, and the demand for labor curve, LD1, once the real wage has fallen from w0 to w1. At w1, the quantity of labor demanded is again exactly equal to the quantity of labor supplied. Equilibrium employment has declined from L0 to L1.
The lower equilibrium employment would have reduced the marginal product of capital, decreasing the demand for capital and reducing the real cost of capital.
The decline in equilibrium employment from L0 to L1 reduces the equilibrium level of economic output from Y0 to Y1 along the new, lower production function Y = A1*F(K0, L).
Once general equilibrium has been re-established, Iceland's (1) equilibrium economic output would have been reduced from Y0 to Y1, (2) equilibrium employment would have been reduced from L0 to L1, (3) the equilibrium real wage would have been reduced from w0 to w1, and (4) the real rental cost of capital would have declined.