LEARNING OBJECTIVES
After you have read this section, you should be able to answer the following questions:
How are the markets for goods, labor, credit, and foreign currency linked?
How do we use those links to understand the crisis that began in 2008?
In "Three Important Markets", we talked about the markets for credit, labor, and foreign exchange. 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.
But the story of the economic crisis in 2008 was not about a single market. 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. These different markets are connected; in this section, we explore these linkages. We do so through the circular flow of income, shown in ***Figure 4.16 "The Circular Flow of Income". That model of the economy reveals the linkages across markets that the global financial crisis made so evident.
Toolkit: Section 16.16 "The Circular Flow of Income"
You can review the circular flow of income in the toolkit.
We know from the circular flow that the production of goods and services generates income in an economy. Some of that income is paid to the government in the form of taxes, but the rest finds its way to households. Much of the flow of dollars from firms to households takes place through the labor market because firms demand labor to produce goods. 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.
Some of the income that households earn from selling labor services is saved. There is therefore a link, through the household sector, between the labor market and the credit market. 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. There is also a link from the markets for goods and services to the demand for credit: firms borrow to purchase investment goods.
These markets are also linked—directly or indirectly—to foreign exchange markets. Whenever firms purchase imported goods, such as oil, this generates a demand for foreign exchange. 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. When households and firms in other countries want to buy our goods and services, that generates a supply of foreign exchange. And many transactions in credit markets also generate a demand for or supply of foreign exchange.
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