Ft. Myers, Florida, was a boom town from 2003 to 2005. Jobs were plentiful: the unemployment rate in the Ft. Myers–Cape Coral metropolitan area was less than 3%. Shopping malls were humming, and new stores were opening everywhere.

But then the boom went bust. Jobs became scarce, and by the middle of 2010, the unemployment rate was above 13%. Stores had few customers, and many were closing. One new business was flourishing, however. As the local economy plunged, real estate agents began offering “foreclosure tours”: visits to homes that had been seized by banks after the owners were unable to make mortgage payments—and were available at bargain prices.

What happened? Ft. Myers boomed from 2003 to 2005 because of a surge in home construction, fueled in part by speculators who bought houses not to live in, but to resell at much higher prices. Home construction gave jobs to construction workers, electricians, roofers, real estate agents, and others. These workers, in turn, spent money locally, creating jobs for school teachers, bus drivers, sales people, and more. These workers, in turn, also spent money locally, creating further expansion, and so on.

The boom turned into a bust when home construction suddenly 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 others who were also buying houses as investments, and prices rose to levels far beyond what people who actually wanted to live in houses were willing to pay. Eventually there was a “Wile E. Coyote moment”—named after the cartoon character who has a habit of running off the edge of cliffs but doesn’t fall until he looks down and realizes that nothing is supporting him. In 2005 people looked down—and suddenly realized that home prices had lost touch with reality. And when they did, the housing market collapsed.

The local economy then collapsed, as the process that had created the earlier boom operated in reverse. The jobs created by home construction went away, leading to a fall in local spending, leading to a loss of other local jobs, leading to further declines in spending, and so on.

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

In this chapter we’ll study how this process works, showing how multiplier analysis helps us understand the business cycle. As a first step, we introduce the concept of the multiplier informally.