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This is a€?Linkages across Marketsa€?, section 4.4 from the book Theory and Applications of Macroeconomics (v.
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DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators. In Section 4.3 "Three Important Markets", we talked about the markets for credit, labor, and foreign exchange.
We know from the circular flow that the production of goods and services generates income in an economy.
We could go on, but the point should be clear: the markets in every economy are intimately interconnected. The story began with the first comparative static example that we looked at: a leftward shift in demand for housing. If you run a business, you often have to rely on credit (loans) to finance the purchase of your inputs into the production process.
Higher interest rates lead to higher prices and lower quantities for most goods and services. The effect of the higher interest rates on the output decisions of firms also leads them to demand less of all their inputs, including labor. Higher interest rates lead to a leftward shift in supply, and lower income leads to a leftward shift of demand, resulting in lower quantities for most goods and services.
From fewer shoe shines to a slowdown in corporate art purchases, subtle bellwethers can help take the temperature of business activity. Nelson Villanova doesna€™t need to watch the stock market indexesa€¦or gross domestic product to gauge the health of the economy. Villanova, general manager of Eddiea€™s Shoe Repair in New Yorka€™s Grand Central Terminal, has seen business drop 25% to 30% since August. One of the excerpts we used to introduce this chapter touched on the effects of the crisis on exports from China. When demand from these economies slumps, as it did in 2008, exports from China also decrease.
The current account balanceThe difference between the value of exports and imports of goods and services plus net income from foreign assets. The reduced demand for imports from China has an effect on the current account balance of China. The circular flow of income tells us something powerful: whenever we import more than we export, we must, on net, be borrowing from abroad. Both China and the United States trade with many other countries, so this pattern of trade holds true bilaterally (that is, between them) as well. US Secretary of State Hillary Clinton yesterday urged China to keep buying US debt as she wrapped up her first overseas trip, during which she agreed to work closely with Beijing on the financial crisis. The crisis began with a reduction in the demand for houses and a consequent decrease in the value of houses.
Markets are linked because supply and demand in one market generally depend on the outcomes in other markets. We have explained that increases in interest rates shift the supply of goods leftward, and decreases in incomes shift the demand for goods leftward. Can you think of a good for which the demand curve might shift rightward when incomes decrease?
See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. We explained that we sometimes look at individual examples of these markets and sometimes at versions of these markets that apply to the economy as a whole. Instead, what started as a problem in the US mortgage market was felt in the housing market in England, the labor market in China, the foreign exchange market in Europe, and many other markets.


Some of that income is paid to the government in the form of taxes, but the rest finds its way to households. There is therefore a link, through the household sector, between the labor market and the credit market. Whenever firms purchase imported goods, such as oil, this generates a demand for foreign exchange.
This has a critical implication for our study of macroeconomics, which is that it both complicates and enriches our comparative static analyses.
Potential buyers of houses started worrying that the future price of houses would decrease. The decrease in housing prices, combined with the complicated way in which mortgages had been sold and resold by financial institutions, meant that many financial institutions found themselves in trouble. Higher costs make it less profitable to produce at any given price, so most businesses cut back on their production. Higher interest rates increase the cost of doing business, so the supply curve for a typical good or service shifts leftward.
Decreases in production lead to decreases in labor demand, as shown in Figure 4.19 "A Decrease in Demand for Labor". The 15-year-old company employs 40 people across five locations in the sprawling train station, shining and repairing shoes and luggage. Since exports are a part of overall spending, this leads firms in China to cut back their production and employment. Because the demand for foreign currency is partly motivated by the desire to buy goods from that country, a decrease in the import of Chinese goods to the United States and other countries leads to a decrease in demand for the Chinese yuan.
We would expect to see a reduction in the current account surplus of China due to the reduction in economic activity of its trading partners. China has run systematic current account surpluses with the United States, meaning that China is lending to the United States.
This reduced the value of assets, particularly mortgage-backed securities, and meant that the supply of credit in the economy shifted inward. First, households and firms in other countries were one source of credit to the US economy.
We have neglected many details, and we have not discussed how government policies also affected interest rates and the demand for goods and services.
Draw diagrams with both shifts at once and show that the quantity definitely decreases, but the price may increase or decrease. You may also download a PDF copy of this book (29 MB) or just this chapter (2 MB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline). Much of the flow of dollars from firms to households takes place through the labor market because firms demand labor to produce goods. So we can follow a connection from the production of goods and services to the supply of credit: if firms produce more, they generate more labor income, so there is more saving supplied by households to the credit market.
When firms expand output, demand more labor, and so generate additional household income, households spend some of this income on imports, again generating a demand for foreign exchange.
You have to buy the clothes to put on display first, and you get your revenues only when you sell the clothes. In turn, decreases in wages and employment (more generally, a decrease in income) lead to decreased demand for goods. This reduction in income leads to a reduction in the demand for goods and services, leading firms to reduce output and employment even further. Looking back at Figure 4.19 "A Decrease in Demand for Labor", recall that part of household spending goes toward the purchase of goods and services produced in other countries. There is a leftward shift in the demand for that currency and thus a lower price in dollars. A country has a current account surplus if the value of exports of goods and services exceeds the value of its imports.
This is just like a household that pays for consumption above its income by means of borrowing. Those loans take many forms, with commentators highlighting Chinese purchases of US government debt. Later chapters in the book provide more tools for understanding these aspects of the crisis, so when we return to the topic in Chapter 15 "The Global Financial Crisis", we can provide a more complete analysis of the crisis.


We do so through the circular flow of income, shown in Figure 4.16 "The Circular Flow of Income". If firms are producing large quantities of goods and services, then they demand lots of labor, and income from the sale of labor services in the economy is high.
There is also a link from the markets for goods and services to the demand for credit: firms borrow to purchase investment goods.
When households and firms in other countries want to buy our goods and services, that generates a supply of foreign exchange. This made financial institutions cautious about lending to each other, so the supply of credit shifted to the left. Weeks or even months may pass between the time you incur your costs and the time you get your revenues. As a consequence, the supply curve for most goods and services shifts leftward, as shown in Figure 4.18.
The interaction between income and spending on goods and services can lead to much larger reductions in output and employment than the original shift in demand in the original market (in this case, the housing market). Rather, it was a shift in the demand for shoeshines because these traders saw that their incomes were decreasing. A country has a current account deficit if the value of imports of goods and services exceeds the value of its exports. The rules of national income accounting tell us that the flows in and out of each sector must always be in balance. This is not done out of generosity; they do so because they expect to be repaid at some point in the future.
US Secretary of State Hilary Clinton alluded to this connection between the two economies during a visit to China in early 2009. Since many firms in the economy borrow to finance production, the increased interest rates increased their marginal costs of production. That model of the economy reveals the linkages across markets that the global financial crisis made so evident. And many transactions in credit markets also generate a demand for or supply of foreign exchange.
But we now know that the outcome in one market (for example, the real wage) can affect supply and demand in other markets (for example, the supply of credit).
Unless you have the funds available to buy all your stock up front, you will need to borrow.
Looking at the United States and China, one sees very different behavior for the current account.This discussion draws on data from the International Monetary Fund. If we export more than we import, then this flow goes in the other direction, and we are lending to abroad. In addition, as the US economy went into recession, it purchased fewer imports from other countries. In advanced studies in economics, we use complicated mathematics to see if there are prices that are consistent with all the markets being in equilibrium at once. Part (a) of Figure 4.17, which we already saw earlier in the chapter, shows us that this led to a decrease in both the price and the quantity of houses. That figure shows the effects of interest rates on the supply of goods but does not include the reduction in demand stemming from the interaction of income and spending in the circular flow. The bottom line is good news: we can usually be confident that there is an equilibrium for all markets. In recent years, the United States has run a current account deficit of nearly 5 percent of its gross domestic product (GDP).
But because this is such an advanced area of economics, we do not worry about it further in this book. China, in contrast, has run a current account surplus of about 6.1 percent of its GDP since 2002. In this section, we show how these interactions across markets help us understand the propagation of the 2008 crisis from the US housing market to the economies of the world.



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