A Shift in Demand for Goods

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Notice the connection back and forth between households and firms. As firms reduce their demand for labor services, less income flows to households. This reduction in income leads to a reduction in the demand for goods and services, leading firms to reduce output and employment even further. 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). This means that ***Figure 4.18 does not tell the whole story of goods markets. 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.Figure 4.20 completes the story by adding the shift in demand.

Figure 4.20 Figure 4.20  

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. Higher interest rates increase the cost of doing business. Lower income decreases the demand for goods and services.