The Credit Market in the 2008 Crisis

At the height of the financial crisis of 2008, credit became much more expensive—that is, interest rates increased. Why? As housing prices collapsed in the United States and elsewhere, a substantial number of mortgage loans became nonperforming. This means that borrowers were unable or unwilling to repay these loans and defaulted on them instead. In addition, because banks had sold and resold some of these mortgage loans, it was hard to identify which loans would be repaid and which would not. Some financial institutions that were holding a lot of bad loans went bankrupt, and others were in danger of going under as well.

As a consequence, lenders became much more cautious about the types of loans they made—not only in mortgage markets but also throughout the economy. They were more careful about evaluating the likelihood that borrowers would repay their loans. This led to a reduction in the market supply of credit. The reduced supply of loans in the mortgage market was particularly acute. This appears as a leftward shift of the supply curve in Figure 19.8 "A Reduction in Supply in the Mortgage Market". Nominal interest rates increased, and the quantity of mortgages extended decreased. (The full story of what happened in credit markets is more complicated because central banks around the world also took actions to offset these changes and keep interest rates low.)

Figure 19.8 A Reduction in Supply in the Mortgage Market

As lenders became more cautious about making loans, the supply of mortgage loans shifted leftward. Interest rates in the economy increased, and the quantity of mortgages decreased.

Nominal Interest Rates and Real Interest Rates

Mortgage rates and other interest rates are based on underlying dollar amounts; the interest rate tells you how many dollars borrowers must pay to lenders for each dollar that they borrow. Because they are based on dollar amounts, they are called nominal interest rates. When you see a mortgage rate quoted by a bank or a rate on a credit card, it is a nominal rate.

The nominal rate does not tell us the true cost of borrowing, or return on lending, when there is inflation in an economy. For example, suppose that the nominal interest rate is 5 percent, but inflation is also 5 percent. If you took out a $1,000 loan, you would have to pay back $1,050 next year. But that $1,050 would buy exactly the same amount of real gross domestic product (real GDP)A measure of production that has been corrected for any changes in overall prices. next year as $1,000 does this year—that is what it means to have 5 percent inflation. So, in terms of actual goods and services, you have to pay back the same amount that you borrowed. The real interest rateThe rate of return specified in terms of goods, not money.—that is, the interest rate corrected for inflation—is zero.

The real interest rate gives the true cost of borrowing and lending; it is the real interest rate that actually matters for the decisions of savers and borrowers.We derive the Fisher equation more fully in Chapter 24 "Money: A User’s Guide". That doesn’t mean, by the way, that our previous two diagrams were incorrect because they used the nominal interest rate. Provided that the inflation rate doesn’t change, a comparative static exercise using the nominal interest rate will give you exactly the same conclusion as one using the real interest rate.

Individual Credit Markets and the Aggregate Credit Market

We have described a market for a particular kind of loan, but more generally we know that there are all kinds of different ways in which credit is offered in an economy. Households borrow from banks to buy houses or cars. Households and firms make purchases using credit cards. Firms borrow from financial institutions to buy new equipment. The government borrows to finance its spending, and so on. There is a very large number of credit markets in the economy, each offering a different kind of credit, and each with its own equilibrium interest rate.

These different credit markets are linked because most households and firms buy or sell in more than one market. Financial institutions in particular trade in large numbers of different credit markets. For much of what we do in macroeconomics, however, the distinctions among different kinds of credit are not critical, and it is sufficient to imagine a single aggregate credit market and a single real interest rate.In Chapter 24 "Money: A User’s Guide", we look in more detail at the different kinds of credit—and the associated different interest rates—that we see in an economy. We also investigate in more detail how these markets are linked together. Figure 19.9 "The Aggregate Credit Market" shows the credit market for an entire economy. This is the market where all the savers in the economy bring funds to financial intermediaries, who then lend those funds to firms, households, and governments. The supply of credit increases as the interest rate increases. As the interest rate increases, other things being equal, households will generally save more and thus supply more to the credit market. The quantity of credit demanded decreases as the interest rate increases. When it is expensive to borrow, households and firms will borrow less.

Figure 19.9 The Aggregate Credit Market

In the credit market, the equilibrium real interest rate is where the quantity of credit supplied equals the quantity of credit demanded.

Two of the most important players in the credit market are the government and the monetary authority. If the US federal government borrows more, this shifts the demand for credit outward and increases the interest rate. (Notice that the government is a big player in this market, so its actions affect the interest rate.) The monetary authority, meanwhile, buys and sells in credit markets to influence interest rates in the economy.We study the actions of the Federal Reserve and other monetary authorities in Chapter 25 "Understanding the Fed". In the 2008 crisis, the Federal Reserve Bank, which is the monetary authority in the United States, took many actions to increase the supply of credit and ease the problems in the credit market.

The Labor Market in the 2008 Crisis

In the United Kingdom, there was a leftward shift in demand for housing (just like we showed in Figure 19.6 "A Decrease in Demand for Housing"). The response of homebuilders to such a shift is to build fewer homes and, therefore, demand less labor. As a result, there is a leftward shift in the demand curve for construction workers. Based on the supply-and-demand framework, we predict both lower wages and a reduction in employment in the construction sector of the economy, as shown in Figure 19.11 "A Decrease in Demand for Construction Workers".

Similar reductions in demand for labor occurred in the United States and many other countries around the world. There was a consequent reduction in employment and an increase in unemployment. The crisis was not restricted just to financial markets, in other words. It had consequences for the “real” economy as well.

Individual Labor Markets and the Aggregate Labor Market

Because there are many different jobs and many different kinds of workers, there is no single labor market and no single wage. Instead, you can think of there being many different labor markets just as there are many different credit markets. Like different credit markets, different labor markets are linked: households may participate in more than one labor market, and most firms purchase many different kinds of labor. As with the credit market, we sometimes look at the market for a particular kind of labor and the economy as a whole. Most of the time in macroeconomics, it is sufficient to think about an aggregate labor market, as shown in Figure 19.12 "Equilibrium in the Labor Market".In Chapter 23 "Jobs in the Macroeconomy", we pay more attention to the fact that workers and jobs are not all identical. As the real wage increases, households supply more hours, and more households participate in the labor market. For both of these reasons, as the real wage increases, the quantity of labor supplied also increases. Labor demand comes from firms. As the real wage increases, the cost of hiring extra labor increases, and firms demand fewer labor hours. That is, the firm’s labor demand curve is downward sloping.

Figure 19.12 Equilibrium in the Labor Market

The labor market is the market in which firms hire workers. The equilibrium real wage is the price where the quantity of labor supplied equals the quantity of labor demanded.

Foreign Exchange Markets in the 2008 Crisis

One of the articles we used to open this chapter dealt with changes in the value of the dollar in the fall of 2008. The article pointed out that the dollar was getting stronger relative to other currencies, such as the euro. This means that the price of a dollar in euros was increasing or, equivalently, the price of a euro in dollars was decreasing. In fact, the euro price of a dollar was about 0.67 in late September 2008; the price increased to nearly 0.81 by late October and then decreased again through December 2008.

We can use the foreign exchange market to understand these events. Figure 19.14 "Comparative Statics in the Euro Market" shows the dollar market for euros once again. The increase in the value of the dollar discussed in the article is seen here as a rightward shift in the supply of euros, which decreases the value of the euro and—equivalently—increases the value of the dollar.

Figure 19.14 Comparative Statics in the Euro Market

The rightward shift in the supply of euros leads to a decrease in the price of a euro in terms of dollars.

There are two consequences of this shift in the supply curve. First, the shift in supply decreases the dollar price of the euro. So people in the United States who are planning to visit, say, France will find that they can obtain more euros for a given amount of dollars. Second, the quantity of euros actually bought and sold is higher. This is not inconsistent with the lower dollar price of a euro since the supply curve shifts along the demand curve for euros.

Individual Foreign Exchange Markets and the Aggregate Foreign Exchange Market

We sometimes look at an individual exchange rate (e.g., dollar-euro) by thinking of the market where dollars are exchanged for euros. However, there are many different currencies that are exchanged for the US dollar. There are markets where dollars are exchanged for British pounds, Japanese yen, and so on. We can combine these into an aggregate foreign exchange market. Think of this as being the market where US dollars are bought with and sold for all the other currencies in the world. In this market, there is an aggregate exchange rate, which you can think of as an average of the exchange rates in all the individual markets.More precisely, you should think of a weighted average. Because the United States trades much more with Canada than with, say, South Africa, movements in the US dollar–Canadian dollar exchange rate matter more than movements in the US dollar–South African rand exchange rate. Chapter 24 "Money: A User’s Guide" has more on exchange rates. We show this market in Figure 19.15 "Foreign Exchange Market Equilibrium".

Figure 19.15 Foreign Exchange Market Equilibrium

Currencies are traded in foreign exchange markets, such as the market shown here in which dollars are bought and sold.