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Chapter 4 The Interconnected Economy

A Financial Crisis in the News

Here are some headlines from the fall of 2008. If you were following the news during this time period, you probably saw stories like these. The first excerpt talks about houses in the United States.

Fallout from Financial Crisis Hammers Housing

The nation is on track to build fewer homes this year than at any time since the end of World War II, adding to the woes of an economy that analysts said Friday has almost certainly entered a recession.

[…]

David Seiders, chief economist for the group, said builders are being hit by a double whammy from the financial turmoil: It’s harder for them to get loans to pursue new houses, and more difficult to sell those they do build.

[…]Martin Crutsinger, “Fallout from Financial Crisis Hammers Housing,” USA Today, Money, October 17, 2008, accessed June 28, 2011, http://www.usatoday.com/money/topstories/2008-10-16-3784489146_x.htm.

The next excerpt also concerns housing but this time in the United Kingdom.

Financial Crisis: House-Price Slump to Cost Economy £50 Billion

House prices are set to fall 35 per cent from last year’s peak, as the property slump costs the wider economy almost £50bn as people stop buying homes, economists warned.

With house prices predicted to make their biggest fall in British history by dropping 35 per cent by autumn next year, the associated consumer spending is expected to plunge, they said.

[…]

This is expected to have a huge impact on the wider economy as each house sale triggers around £4,000 in new spending on household goods, on items such as washing machines and other white goods.

[…]

The lack of spending in these areas will hit employment, with some analysts forecasting that the construction sector alone could see a loss of up to 350,000 jobs within the next five years.

[…]Myra Butterworth, “Financial Crisis: House-Price Slump to Cost Economy £50 Billion,” The Telegraph, October 21, 2008, accessed June 28, 2011, http://www.telegraph.co.uk/finance/economics/houseprices/3235741/Financial-crisis-House-price-slump-to-cost-economy-50-billion.html.

Taking these excerpts together, we notice four things: (1) There was a housing slump—fewer houses being bought and sold, and house prices decreasing—in both the United Kingdom and the United States at around the same time. (2) Both are linked to a financial crisis. (3) These slumps affect other parts of the economy. (4) The housing problems lead to job losses.

The next excerpt tells us that the crisis also affected the value of the US dollar.

Financial Crisis Has One Beneficiary: The Dollar

The great market upheaval of 2008 has stripped 45 percent from the value of global equities, led bank lending to nearly dry up and caused commodity prices to crash from stratospheric heights. And now, paradoxically, it is helping to lift the long-suffering dollar.

[…]See David Jolly, “Global Financial Crisis Has One Beneficiary: The Dollar,” New York Times, October 22, 2008, accessed June 28, 2011, http://www.nytimes.com/2008/10/22/business/worldbusiness/22iht-dollar.4.17174760.html.

This excerpt tells us that the financial crisis has also affected other prices in the economies of the world. The price of equities—shares in companies—decreased, as did the price of goods such as basic minerals (copper and tin, for example) and basic foods (rice and coffee, for example). But even as these items became less valuable, the US dollar became more valuable. The price of the US dollar increased.

The Chinese economy was also affected by the crisis:

Agricultural Products Export Growth Slows Down in 2008

China’s agricultural products exports rose 9.8 percent year-on-year in 2008 to $40.19 billion, the General Administration of Customs said on Wednesday.

According to the statistics, export growth declined 8.2 percentage points from a year earlier. Exports in the last two months of 2008 fell 6.9 percent and 7.2 percent to $3.47 billion and $3.76 billion respectively over the same period of 2007.

Although the country has increased export rebates for some agricultural products and lowered or even canceled the export tax, exports are unlikely to see a quick rebound in the near future. Poor overseas demand and falling prices in the international market amid the financial crisis, as well as the increasing distrust in China’s food quality are likely to stifle export growth, the General Administration of Customs said.

[…]See Tong Hao, “Agricultural Products Export Growth Slows Down in 2008,” China Daily, February 11, 2009, accessed June 28, 2011, http://www.chinadaily.com.cn/bizchina/2009-02/11/content_7467089.htm.

The excerpt tells us that China’s exports of agricultural products have been growing rapidly, reaching a growth rate of nearly 10 percent in 2008. But they had been growing even faster in the previous year. The effects of the financial crisis and the economic downturn are clear: the amount of exports decreased at the end of 2008 (and in fact fell throughout 2009 as well).

We have shown a few headlines about the impact of the 2008 financial crisis. We could have picked thousands of others. For example, if you enter into a search engine the terms financial crisis and XYZ, where XYZ is just about any product or international currency, you will probably find dozens, perhaps hundreds, of articles. The financial crisis of 2008 affected just about every market—all around the world.

Our task in this chapter is certainly not to fully understand these events. Our goals here are much more modest. First, we want to develop the supply-and-demand framework—perhaps the most basic tool in economics—to understand how an event affecting some good or service leads to changes in the price of that good or service as well as changes in the quantity that is bought and sold. Second, we want to explore some of the ways in which different markets in the economy are linked, for linkages across markets are among the most important features of macroeconomic analysis. The financial crisis is a good illustration because this single event affected so many markets.

Understanding the sources and consequences of changing prices and quantities in the economy is one of the key tasks of an economist. There is an almost endless list of such analyses in economics. In fact, most of the applications in this textbook ultimately come down to understanding, explaining, and predicting changes in prices and quantities. The two questions that motivate this chapter are as follows:

What determines price and quantity in a market?

How are markets interconnected?

Road Map

The story of the crisis of 2008 is fascinating and worth understanding in some detail. We begin with the basics of supply and demand, looking at a single market—the market for houses. We explain how the equilibrium price and quantity in this market are determined, which allows us to understand why the price of housing changes. This is a first step to understanding the crisis of 2008 because the housing market was central to that story.

The story began in the housing market but did not end there. It spread across the economy and across the world. Hence we next look at three significant markets in the economy: the labor market, the credit market, and the foreign exchange market. Understanding how these three markets work is necessary for a good understanding of macroeconomics. We use these markets to provide more illustrations of supply and demand in action. Finally, we look at how markets are linked together to see how what might have seemed like a minor problem in one market turned into a cataclysmic event for the world’s economies.

Throughout this chapter, we use the term “the crisis of 2008” as shorthand, but the first signs of the crisis emerged well before that year, and the effects of the crisis are still being felt several years later. The crisis was a complex event, and right now, at the beginning of your studies of macroeconomics, we are not yet ready to delve deeply into a detailed analysis of those events. We return to the crisis in Chapter 15 "The Global Financial Crisis", which is a capstone chapter that brings together most of the tools of macroeconomics from this book.