ChainWhat it assumes · how to break it
Start
Banks suffer large losses on mortgage-related loans and securities as house prices fall, as in the 2007–08 global financial crisis, and begin to doubt each other's solvency.
1
As a result, banks stop lending to each other in the interbank market because they cannot tell which banks hold the bad assets, so funding costs rise and credit dries up.
credit crunch · asymmetric information
credit crunch · asymmetric information
Assumes: Banks cannot judge each other's exposure to bad loans.
But: If the central bank acts as lender of last resort and supplies liquidity freely, banks can fund themselves without relying on each other.
2
This means banks with depleted capital tighten lending to firms and households, charging higher rates and demanding larger deposits on mortgages.
credit rationing · capital adequacy
credit rationing · capital adequacy
Assumes: Banks rebuild capital by shrinking their lending.
But: If the government injects capital, as the UK did with RBS and Lloyds in 2008, banks need not cut lending as much to restore their capital ratios.
3
Consequently, investment falls because firms cannot finance projects, and consumption falls as households lose access to credit and house prices fall.
investment · consumption · negative wealth effect
investment · consumption · negative wealth effect
Assumes: Firms and households depend on bank credit to spend.
But: Large firms can borrow directly through bond markets or use retained profits, and many households have little debt, so much spending does not depend on bank credit.
4
Therefore, aggregate demand and output fall, and because labour is a derived demand, firms need fewer workers.
AD · derived demand
AD · derived demand
Assumes: The fall in demand is expected to last.
But: If firms expect a quick recovery, they may keep workers to avoid the cost of firing and later rehiring them.
5
As a result, firms freeze hiring and make workers redundant, so cyclical unemployment rises.
cyclical unemployment
cyclical unemployment
Best link to attack
Assumes: Firms cut jobs rather than pay or hours.
Assumes: Firms cut jobs rather than pay or hours.
But: In the UK after 2008, many firms froze pay and cut hours instead, so unemployment rose by less than the fall in output suggested.
6
Consequently, workers who stay unemployed for long periods lose skills and contacts, so some cyclical unemployment becomes long-term structural unemployment.
hysteresis · structural unemployment
hysteresis · structural unemployment
Assumes: The downturn lasts long enough for skills to decay.
But: If the recovery is quick, most workers are re-employed before their skills fade.
End
Unemployment rises as firms cut jobs in the recession, and some of it may persist as long-term unemployment.
Evaluation chain
- E1However, the rise in unemployment depends on whether firms cut jobs or adjust pay and hours instead.
- E2When nominal pay is frozen while prices keep rising, real wages fall and firms can keep workers at lower cost.
- E3As a result, firms hoard labour, and output per worker falls instead of employment.
- E4So unemployment rises by less than the fall in output suggests, although falling real wages and underemployment still reduce living standards.
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Questions this answers
- Assess the impact of a banking crisis on unemployment.
- Evaluate why unemployment rose less than expected in the UK after the 2008 recession.
- Discuss whether a recession caused by a financial crisis leads to long-term unemployment.
Diagram
AD/AS: AD shifts left and real GDP falls below its full-employment level. A labour market diagram with the demand for labour shifting left also works.
Reverse and related
Recovery in bank lending → spending and output recover, firms hire again and unemployment falls.