1. 19-1 Economics: Theory Through Applications

2. 19-2 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA

3. 19-3 Chapter 19 The Interconnected Economy

4. 19-4 Learning Objectives What factors underlie the demand for housing? What factors underlie the supply of housing? What determines the amount of housing traded and the price of housing? What are exogenous and endogenous events? How does the equilibrium of a market respond to changes in exogenous variables? What is comparative statics and how is it used?

5. Learning Objectives What is the credit market and what determines the interest rate? What is the labor market and what determines the real wage? What is the foreign currency market and what determines the exchange rate? 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? 19-5

6. Figure 19.1 - The Market Demand for Houses 19-6

7. Figure 19.2 - A Shift in the Market Demand Curve 19-7

8. Figure 19.3 - The Market Supply of Houses 19-8

9. Figure 19.4 - A Shift in Supply of Houses 19-9

10. Figure 19.5 - Market Equilibrium 19-10

11. Table 19.1 - Market Equilibrium: An Example 19-11

12. Figure 19.6 - A Decrease in Demand for Housing 19-12

13. The Credit Market 19-13

14. Figure 19.7 - A Market for $1,000 Loans 19-14

15. Figure 19.8 - A Reduction in Supply in the Mortgage Market 19-15

16. Nominal Interest Rates and Real Interest Rates 19-16

17. Figure 19.9 - The Aggregate Credit Market 19-17

18. Figure 19.10 - Equilibrium in the Market for Construction Workers 19-18

19. Figure 19.11 - A Decrease in Demand for Construction Workers 19-19

20. Figure 19.12 - Equilibrium in the Labor Market 19-20

21. Figure 19.13 - Equilibrium in the Foreign Exchange Market Where Dollars and Euros Are Exchanged 19-21

22. Figure 19.14 - Comparative Statics in the Euro Market 19-22

23. Figure 19.15 - Foreign Exchange Market Equilibrium 19-23

24. Figure 19.16 - The Circular Flow of Income 19-24

25. Figure 19.17 19-25

26. Figure 19.18 19-26

27. Figure 19.19 - A Decrease in Demand for Labor 19-27

28. Figure 19.20 19-28

29. Figure 19.21 - A Decrease in Demand for Shoeshines 19-29

30. Trade Flows and a Shift in the Demand For Foreign Exchange 19-30

31. Key Terms Supply and demand: Supply and demand is a framework to explain and predict the equilibrium price and equilibrium quantity of a good Competitive market: A market is said to be competitive, or more precisely to exhibit perfect competition, when there are many buyers and sellers and the goods produced by the sellers are perfect substitutes Market demand curve: The number of units of a good or a service demanded at each price Market supply curve: The number of units of a good or a service supplied at each price 19-31

32. Key Terms Equilibrium price: A price such that the quantity supplied equals the quantity demanded Equilibrium quantity: The quantity supplied and demanded at the equilibrium price 19-32

33. Key Terms Exogenous: Something that comes from outside a model and is not explained in our analysis. Endogenous: Something that is explained within our analysis Comparative statics: Comparative statics is a technique that describes how market equilibrium prices and quantities depend on exogenous events Nominal interest rate: The nominal interest rate is the number of additional dollars that must be repaid for every dollar that is borrowed Real interest rate: The rate of return specified in terms of goods not money 19-33

34. Key Terms Fisher equation: A formula for converting from nominal interest rates to real interest rates: the real interest rate equals the nominal interest rate minus the inflation rate Credit market: The credit market brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. Real wage: The real wage is the relative price of labor in terms of consumption goods – It equals the nominal wage (the wage in dollars) divided by the price level 19-34

35. Key Terms Labor market: The labor market is the market which brings together households who supply labor services and firms who demand labor as an input into the production process Foreign exchange market: A foreign exchange market is where one currency is traded for another Nominal exchange rate: The nominal exchange rate is the price of one currency in terms of another Current account balance: The current account balance is the difference between the value of exports and imports of goods and services Net exports: Net exports equals exports minus imports 19-35

36. Key Takeaways The primary factor influencing the demand for housing is the price of housing – By the law of demand, as the price of housing falls, the quantity of housing demanded increases – The demand for housing also depends on wealth of households, their current income and interest rates The primary factor influencing the supply of housing is the price of housing – As the price increases, the quantity supplied increases as well – The supply of housing is shifted by changes in the price of inputs by changes in technology 19-36

37. Key Takeaways The quantity and price of housing traded is determined by the equilibrium of the housing market Exogenous variables are determined from outside a framework, while endogenous variables are determined within the framework Changes in exogenous variables lead to shifts in market supply and/or market demand curves – These shifts in supply and demand then lead to changes in quantities and prices 19-37

38. Key Takeaways Comparative statics is a technique to describe how changes in exogenous variables influence equilibrium quantities and prices – It is used to answer questions about how markets respond to changes in exogenous variables The credit market brings together the suppliers (households) of credit with those who are demanding credit (other households, firms and the government) – The interest rate adjusts to attain a market equilibrium 19-38

39. Key Takeaways The labor market is where labor services are traded – Households supply labor and firms demand labor – The real wage adjusts to attain a market equilibrium The foreign exchange market brings together demanders and suppliers of foreign currency – The exchange rate, which is the price of one currency in terms of another, adjusts to attain a market equilibrium 19-39

40. Key Takeaways Markets are linked because supply and demand in one market will generally depend on the prices 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 19-40