The crisis began with a reduction in the demand for houses and a consequent decrease in the value of houses. This reduced the value of assets, particularly mortgage-backed securities, and meant that the supply of credit in the economy shifted inward. The consequence was higher interest rates and reduced credit. Since many firms in the economy borrow to finance production, the increased interest rates increased their marginal costs of production. Supply curves throughout the economy shifted inward, leading to lower output. Firms needed fewer workers, so there was a reduction in employment.
The spread to other countries came through a couple of avenues. First, households and firms in other countries were one source of credit to the US economy. When asset prices decreased, the portfolios of foreign banks were also adversely affected. This led to higher interest rates and lower output in those countries. In addition, as the US economy went into recession, it purchased fewer imports from other countries. This led to lower production in those countries.
Our description of the crisis is of necessity a simple one. We have neglected many details, and we have not discussed how government policies also affected interest rates and the demand for goods and services. 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.
KEY TAKEAWAY
Markets are linked because supply and demand in one market generally depend on the outcomes in other markets. The circular flow of income illustrates some of these connections across markets.
Although the crisis in 2008 may have started in the housing market, it did not end there. Instead, the crisis impacted markets for labor, credit, and foreign exchange.
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Checking Your Understanding
We have explained that increases in interest rates shift the supply of goods leftward, and decreases in incomes shift the demand for goods leftward. Draw diagrams with both shifts at once and show that the quantity definitely decreases, but the price may increase or decrease.
Can you think of a good for which the demand curve might shift rightward when incomes decrease?
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