Early critics of real business cycle models claimed that these models could not explain major events like the Great Depression, and, indeed, there appears to be a puzzle about the Great Depression. If negative technology shocks were responsible for the origin and decade-long persistence of the Great Depression, we would expect that the fall in output would be accompanied by a decline in the real wage, just as in Figure. However, real wages actually rose substantially during the 1930s.

Economists Harold L. Cole and Lee E. Ohanian of the University of California, Los Angeles, extended the standard real business cycle model to include other important factors, in particular government interventions that affected the labor market. For example, President Franklin Roosevelt s New Deal featured the National Industrial Recovery Act, which allowed firms to collude with one another and avoid competition as long as they recognized unions and raised wages. Prior to the onset of the Great Depression, President Herbert Hoover also promoted policies that led firms to raise wages. Ohanian and Cole show that incorporating these factors into a standard real business cycle model can explain both the origin and severity of the GreatDepression.

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Labor supply Labor demand before shock Labor demand after shock Labor