Wendy Carlin
Under construction, West Brunswick, Melbourne

Unit 3 Aggregate demand and the multiplier model

How economies fluctuate between booms and recessions as they are continuously hit by good and bad shocks

Before you start

To develop the models in this unit, we will use the economic concepts and modelling principles set out in Section 2.8 of the microeconomics volume. You should be familiar with these before beginning work on this unit.

3.1 The ‘great recession’: Hardship at home and at work

In 2006, Lisa bought a house in Florida. Things were going well for her family: she and her husband were expecting their second baby; they’d established a successful web design company that brought them a high income. The housing market was booming and large mortgages were easily available, but she wanted to take some time off to care for the children and was careful not to borrow more than they could comfortably afford to repay.

Then came the global financial crisis. It started in 2007 when US house prices began to fall, and spread through financial institutions across the world. The investment bank Lehman Brothers, which collapsed in September 2008, was just one of many bank failures. And the whole global economy was affected: the financial crisis led to a sustained fall in output in many countries, sometimes described as ‘the great recession’. By mid-2009, the gross domestic product (GDP) of the US—that is, its aggregate output—had declined by 4.3%.

Everything began to go wrong for Lisa. Business declined—people were no longer buying bespoke website designs. And as she says, ‘Desperate times can really change people.’ Her husband panicked when he realised the business was in serious trouble; he took all of the family’s money, and disappeared.

Lisa was left with a mortgage and two small children to provide for. The market value of her house was falling rapidly. The business was gone, and her debts were accumulating. She says: ‘I had to learn to be poor again.’ She took on three jobs, and her parents took care of the children while she worked. The recession led to a crime wave in her neighbourhood—the family was robbed repeatedly.

In 2011, Lisa was declared bankrupt. She stopped repaying the mortgage and the bank repossessed her house.

In the succeeding years, Lisa was able to rebuild her life. But the experience left its mark. Reflecting back on it 10 years after the collapse of Lehman Brothers, she says, ‘I feel less safe now than I did before the crisis … Corporate America might get a bailout, but no one was going to bail me out.’

The total output of a country, and the incomes of its residents, fluctuate from month to month. On average they tend to grow. But periodically we experience recessions, when output and incomes fall month after month and sometimes for periods of a year or more, typically leading to rising unemployment. And sometimes we experience booms—periods when output rises rapidly and unemployment falls.

All recessions affect the prosperity and well-being of individuals, although the ‘great recession’ was unusually widespread and, in many countries, unusually deep. Lisa’s story illustrates that booms and recessions—although they may only last a few months or years, and the change in output may sound quite small—can have much bigger and longer-lasting effects on individuals and families. Figure 3.1 shows that Americans experienced many different recession-related hardships during the same period.

Question: Since the recession began in 2008 have you … Percentage answering Yes
Work-related stress Lost a job? 14.1
Started a new job you did not like? 6.1
Taken a job below education/experience? 12.0
Taken an additional job? 10.1
Home-related stress Missed mortgage or rent payment? 5.9
Been threatened with foreclosure/eviction? 4.4
Sold a home for less than it cost you? 4.6
Lost a home to foreclosure? 2.1
Lost a home to something other than foreclosure? 2.1
Had family/friends move in to save money? 12.5
Moved in with family/friends to save money? 4.2
Financial stress Declared bankruptcy? 3.0
Missed a credit card payment? 10.4
Missed other debt payments, car/student loans? 5.0
Increased credit card debt? 21.8
Sold possessions to make ends meet? 13.4
Cut back on your spending? 62.8
Exhausted unemployment benefits? 7.6

Figure 3.1 Recession hardships in the United States: survey results for 2013–2014.

Note: Representative sample of 1,739 Americans aged 25–74; survey conducted in 2013–14.
Jonathan Koltai and David Stuckler. 2020. ‘Recession Hardships, Personal Control, and the Amplification of Psychological Distress: Differential Responses to Cumulative Stress Exposure During the US Great Recession’. SSM - Population Health 10, 100521.

The US unemployment rate rose from 5% to 10% between 2007 and 2009; by 2013, it was still around 7%. One in seven of those surveyed had lost a job during this period. One in ten, like Lisa, took on additional jobs. More than 4%, like her, lost their home, and still more were at risk of doing so. Others didn’t suffer such extreme effects, but many struggled with debt, and a high proportion—63% of all respondents—cut back on spending.

To explore the correlation between GDP per capita and life satisfaction, go to Our World in Data. To explore the Human Development Index data, try the Doing Economics project on ‘Measuring Wellbeing’.

gross domestic product (GDP)
A measure of the total output of goods and services in the economy in a given period.

In this unit, we learn about why economies go through upswings, during which aggregate output rises and unemployment falls, and downswings (falling output, rising unemployment). We focus on the total spending (by households, firms, the government, and people outside the home economy) on the goods and services produced by people employed in the home economy. This method gives us a way of measuring the gross domestic product. By itself, GDP does not measure well-being, but it is correlated with some variables that do—such as those included in the UN’s Human Development Index, in the OECD’s Better Life Index (Exercise 3.1)—and to measures of subjective well-being or ‘happiness’.

In Exercise 3.1, we show you a tool that you can use to examine your ideas about how the overall well-being in a country can be compared with well-being in other countries. What is your recipe for a better life in your country? How important do you think unemployment is? Do other things matter more or just as much—for example, good education, clean air, a high level of trust among citizens, high income, or not too much inequality?

The OECD is an international organization based in Paris, with 35 member countries, most with high levels of GDP per capita. It was formed in 1948 to facilitate post-war reconstruction in Western Europe. The OECD is an important source of internationally comparable statistics on economic and social performance.

Exercise 3.1 The OECD Better Life Index

The Better Life Index was created by the Organization for Economic Cooperation and Development (OECD).

It lets you design a measure of the quality of life in a country by deciding how much weight to put on each component of the index.

  1. Should a better life index include the following elements: income, housing, jobs, community, education, environment, civic engagement, health, life satisfaction, safety, and work–life balance? For each of these elements, explain why or why not.
  2. Use the Better Life Index tool to create your own better life index for the country where you are living. How does this country score on the topics that are important to you?
  3. Rank the countries in the database using your own newly created better life index, and compare it with a ranking based exclusively on income.
  4. For both of these indices, choose two countries with contrasting rankings and briefly suggest reasons for the differences you observe.