About the importance of the multiplier, a number summarizing how initial changes in spending lead to further changes
What the aggregate consumption function is
How expected future income and aggregate wealth affect consumer spending
The determinants of investment spending and the distinction between planned investment spending and unplanned inventory investment
How the inventory adjustment process moves the economy to a new equilibrium after a change in demand
Why investment spending is considered a leading indicator of the future state of the economy
Ft. Myers, Florida, was a boom town from 2003 to 2005. Jobs were plentiful: the unemployment rate in the Ft. Myers–
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—
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—
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—
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.