Module 16: Income and Expenditure

Module 17: Aggregate Demand: Introduction and Determinants

Module 18: Aggregate Supply: Introduction and Determinants

Module 19: Equilibrium in the Aggregate Demand–Aggregate Supply Model

Module 20: Economic Policy and the Aggregate Demand–Aggregate Supply Model

Module 21: Fiscal Policy and Multiplier Effects

Economics by Example: “How Much Debt Is Too Much?”

Ft. Myers, Florida, was a boom town in 2005. Jobs were plentiful: the unemployment rate was less than 3%. The shopping malls were humming, and new stores were opening everywhere.

But then the boom went bust. Jobs became scarce, and by 2010, the unemployment rate was above 13%. Stores had few customers, and many were closing. One new business was flourishing, however. Marc Joseph, a real estate agent, began offering “foreclosure tours”: visits to homes that had been seized by banks after the owners were unable to make mortgage payments.

What happened? Ft. Myers boomed because of a surge in home construction, fueled in part by speculators who bought houses not to live in, but because they believed they could resell those houses at much higher prices. Home construction gave jobs to construction workers, electricians, real estate agents, and others. And these workers, in turn, spent money locally, creating jobs for sales workers, waiters, gardeners, pool cleaners, and more. These workers also spent money locally, creating further expansion, and so on.

The boom turned into a bust when home construction came to a virtual halt. It turned out that speculation had been feeding on itself: people were buying houses as investments, then selling them to other people who were also buying houses as investments, and the prices had risen to levels far beyond what people who actually wanted to live in houses were willing to pay.

The abrupt collapse of the housing market pulled the local economy down with it, as the process that had created the earlier boom operated in reverse.

The boom and bust in Ft. Myers illustrates, on a small scale, the way booms and busts often happen for the economy as a whole. The business cycle is often driven by ups or downs in investment spending—either residential investment spending (spending on home construction) or nonresidential investment spending (such as spending on construction of office buildings, factories, and shopping malls). Changes in investment spending, in turn, indirectly lead to changes in consumer spending, which magnify—or multiply—the effect of the investment spending changes on the economy as a whole.

In this section we’ll study how this process works on a grand scale. As a first step, we introduce multiplier analysis and show how it helps us understand the business cycle. We then explore how aggregate supply and aggregate demand determine the levels of prices and real output in an economy. Finally, we use the aggregate demand–aggregate supply model to visualize the state of the economy and examine the effects of economic policy.