16 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Stock Market and the Economy

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 41 The Stock Market and the Economy As recently as a decade ago macroeconomics could ignore the stock market because its impact on the economy was small The stock market boom of the last half of the 1990s had a large impact on the economy.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 41 Business Investment and Finance To make a large purchase, a firm can borrow the funds from a bank, but it can also issue a bond. 2.Investment projects are usually very large, often requiring external financing. a.Internal financing means payment out of retained earnings. b.External financing 3.Types of external financing a.Bank loans b. Issuing bonds c. Issuing stock

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 41 Stocks and Bonds A bond is a document that promises to pay back a loan under specified terms and a given period of time. Bonds have several properties: Face value, or the amount the buyer agrees to lend to the bond issuer. Maturity date, or the date when the funds are paid back to the lender (although the lender may sell the bond before maturity).

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 41 Bonds A fixed payment, many bonds make regular payments once or twice a year. These payments are called coupon payments. The coupon is a fixed dollar amount specified in the bond covenant.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 41 Bonds 15-yr. Bond Face Value: $10,000 Coupon rate: 10% Yearly payment of $1,000 Bank Account requires only: $5,000 with interest rate of 20% To obtain same yearly payment of $1,000

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 41 Stocks A stock is a certificate that certifies ownership of a certain portion of a firm. When a firm issues new shares of stock, it does not add to its debt. Instead, it brings in additional “owners” who supply it with funds.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 41 Stocks Stockholders have a right to select the management of the firm and to share in its profits. Unlike bonds or direct borrowing, stocks do not promise a fixed annual payment. Returns depend on company performance. If profits are high, the firm may pay dividends.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 41 Stocks A capital gain is an increase in the value of an asset. A realized capital gain occurs when the owner of an asset actually sells it for more than he paid for it.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 41 Stocks Most stocks bought and sold on the stock market daily are not newly issued but issued long ago, when the firm “goes public.”

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 41 Determining the Price of a Stock Things that are likely to affect the price of a stock include: What people expect its future dividends will be When the dividends are expected to be paid The amount of risk involved

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 41 Determining the Price of a Stock The amount by which future dividends are discounted depends on the interest rate. The larger the interest rate, the more will expected future dividends be discounted. Interest rate10%5% Amount today $100$ Pays one year from now$110

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 41 Determining the Price of a Stock The amount by which future dividends are discounted is greater when the possibility of obtaining dividends from a firm is more uncertain.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 41 Determining the Price of a Stock Thus we can say that the price of a stock should equal the discounted value of its expected future dividends, where the discount factors depend on the interest rate and risk. Announcements of higher expected future dividends or perceived lower risk should increase the firm’s stock price.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 41 Determining the Price of a Stock The price of a stock may also be driven up not by the discounted value of expected future dividends, but by people’s views of what others will pay for the stock in the future. One might call this a bubble because the stock price depends on what people expect that other people expect, etc.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 41 The Stock Market Since 1948 Dow Jones Industrial Average Index: An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 41 The Stock Market Since 1948 NASDAQ Composite Index: An index based on the stock prices of over 5,000 companies traded on the NASDAQ stock market. The NASDAQ market takes is name from the National Association of Securities Dealers Automated Quotation System.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 41 The Stock Market Since 1948 Standard and Poors 500 (S&P 500) Index: An index based on the stock prices of the largest 500 firms traded on the New York Stock Exchange, the NASDAQ stock market, and the American Stock Exchange.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 41 The Stock Market Since 1948 From a macroeconomic perspective, the Dow Jones Industrial Average and the NASDAQ index cover too small a sample of firms. A better measure of the market value of all firms in the economy is the Standard and Poors 500 stock price index, called the S&P 500.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 41 The S&P 500 Stock Price Index, 1948 I – 2002 III

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 41 The Stock Market Since 1948 Between 1995 and 2000, the S&P 500 index rose 226 percent, an annual rate of 25 percent! This is by far the largest stock market boom in U.S. history. This boom added $14 trillion to household wealth, about $2.5 trillion per year.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 41 The Stock Market Since 1948 The stock market boom cannot be explained by a large fall in interest rates, higher profits, or a fall in the perceived riskiness of stocks. This led many people to the view that it was simply a bubble. Millions of lives were affected by the euphoria of the boom and the “correction” that followed.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 41 Growth Rate of S&P 500 Earnings, 1948 I – 2002 III

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 41 Ratio of Profits to GDP, 1948 I – 2002 III

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 41 Stock Market Effects on the Economy An increase in stock prices causes an increase in wealth, and consequently an increase in consumer spending. Investment is also affected by higher stock prices. With a higher stock price, a firm can raise more money per share to finance investment projects.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 41 The Crash of October 1987 The value of stocks in the United States fell by about a trillion dollars between August 1987 and the end of October If the multiplier is 1.4, the $1 trillion decrease in wealth in 1987 implies a $40 billion lower level of spending in 1988, or about 1.4 percent of GDP.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 41 The Crash of October 1987 However, as the life-cycle theory of consumption predicts, households smooth their consumption over time, which means that the decrease in wealth would not have reduced consumption in the current year by the full amount of the decrease in wealth, but by cutting consumption a little each year.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 41 The Crash of October 1987 The stock market crash of 1987 did not result in a recession in 1988 because households and business firms did not lower their expectations drastically. Since the initial decrease in wealth turned out to be temporary, the negative wealth effect was not as large as anticipated.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 41 The Boom of The boom in the economy between 1995 and 2000 was fueled by the stock market boom. Estimates show that had there been no stock market boom the economy would not have looked historically unusual in the last half of the 1990s.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 41 The Boom of The value of stocks increased by about $2.5 trillion per year during the boom. Assuming that a $1 increase in stock prices leads to a $0.04 increase in consumption and investment, and a multiplier of 1.4, then: 0.04 x $2.5 trillion x 1.4 = $140 billion increase in GDP, or 1.5% of GDP. The growth rate of GDP would have been around 2.8% instead of 4.5%

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 41 Personal Saving Rate, 1995 I – 2002 III Had there been no boom: The personal saving rate would have been higher.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 41 Investment Output Ratio, 1995 I – 2002 III Had there been no boom: Firms would have invested less in plant and equipment.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 41 Ratio of Federal Government Budget Surplus to GDP, 1995 I – 2002 III Had there been no boom: The federal government surplus would not have been as high, since taxable income and profits would have been less.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 41 The Boom of Had there been no boom: There would have been no stock market correction in 2001 and 2002, and the growth rate of real GDP would have been higher.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 41 The Unemployment Rate, 1995 I – 2002 III Had there been no boom: The unemployment rate would have remained at about 5.5 percent. It was 4% during the boom.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 41 Inflation Rate, 1995 I – 2002 III Had there been no boom: Inflation would have been lower due to less demand pressure.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 41 3-Month Treasury Bill Rate, 1996 I – 2002 III Had there been no boom: The 3-month Treasury bill rate and interest rates as a whole would have been lower.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 41 Fed Policy and the Stock Market This figure shows that the Fed is influenced by the stock market. The Fed cares about the stock market to the extent that the market affects the things that it ultimately cares about, namely output, unemployment, and inflation.

C H A P T E R 16: The Stock Market and the Economy © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 41 Key Terms and Concepts bond capital gain capital gain Dow Jones Industrial Average Index Dow Jones Industrial Average Index NASDAQ Composite Index NASDAQ Composite Index realized capital gain realized capital gain Standard and Poors 500 (S&P 500) Index Standard and Poors 500 (S&P 500) Index stock