Using All the Theory: The Stock Market and the Macroeconomy © 2003 South-Western/Thomson Learning

Basic Background Why Do People Hold Stock?Why Do People Hold Stock? Tracking the Stock MarketTracking the Stock Market

Basic Background A share of stock is a private financial asset that is a share of ownership in a corporation.

Why Do People Hold Stock? Individuals hold some of their wealth in stocks in order to receive the part of corporate profits that is distributed as dividends. A second - and usually more important - reason that people hold stocks is that they hope to enjoy capital gains.

Tracking the Stock Market Stock and bond prices are monitored on a continuous basis. In addition to monitoring individual stocks, the media keep a close watch on many stock market indices or averages.

Explaining Stock Prices The stock market is a collection of individual, perfectly competitive markets for particular corporations’ shares.

Explaining Stock Prices Stockholders are concerned about both the rate of return and the risk associated with stocks. In practice, they try to allocate their total wealth among a collection of assets - including stocks - that strikes the right balance between risk and return.

Explaining Stock Prices a a a Number of Shares Price per Share E S $ D 298 million

Explaining Stock Prices The supply curve for a stock tells us the quantity of shares in existence at any moment in time. This is the number of shares that people are actually holding.

Explaining Stock Prices The desire to hold a stock is given by the downward-sloping demand curve.

Explaining Stock Prices Only at the equilibrium price - where the supply and demand curves intersect - are people satisfied holding the number of shares they are actually holding.

Explaining Stock Prices The changes we observe in a stock’s price - over a few minutes, a few days, or a few years - are virtually always caused by shifts in the demand curve.

Explaining Stock Prices a a a Number of Shares Price per Share S $75 60 (a) (b) 298 million The demand curve shifts rightward when new information causes expectations of: higher future profits economic expansion lower interest rates Number of Shares Price per Share S 45 $ million The demand curve shifts leftward when new information causes expectations of: lower future profits recession higher interest rates D 2 D 1 D 1 D 3

Explaining Stock Prices Any new information that increases expectations of firms’ future profits - announcements of new scientific discoveries, business developments, or changes in government policy - will shift the demand curves of the affected stocks rightward.

Explaining Stock Prices New information that decreases expectations of future profits will shift the demand curves leftward.

Explaining Stock Prices Any news that suggests the economy will enter an expansion, or that an expansion will continue, will shift the demand curves for most stocks rightward.

Explaining Stock Prices Any news that suggests an economic slowdown or a coming recession shifts the demand curves for most stocks leftward. Any news that suggests an economic slowdown or a coming recession shifts the demand curves for most stocks leftward.

Explaining Stock Prices A rise in the interest rate in the economy will shift the demand curves for most stocks to the left. A drop in the interest rate will shift the demand curves for most stocks to the right.

Explaining Stock Prices News that causes people to anticipate a rise in the interest rate will shift the demand curves for stocks leftward. News that suggests a future drop in the interest rate will shift the demand curves for stocks rightward.

The Stock Market and the Macroeconomy How the Stock Market Affects the EconomyHow the Stock Market Affects the Economy How the Economy Affects the Stock MarketHow the Economy Affects the Stock Market

The Stock Market and the Macroeconomy Stock Market Macroeconomy

How the Stock Market Affects the Economy The Wealth EffectThe Wealth Effect The Wealth Effect and Equilibrium GDPThe Wealth Effect and Equilibrium GDP

The Wealth Effect Autonomous consumption spending tends to move in the same direction as stock prices. When stock prices rise, autonomous consumption spending rises.When stock prices rise, autonomous consumption spending rises. When stock prices fall, autonomous consumption spending falls with it.When stock prices fall, autonomous consumption spending falls with it.

The Wealth Effect and Equilibrium GDP a a a (a)(b) Y 1 Y 2 Real GDP Aggregate Expenditure AE higher stock prices Real GDP Price Level Y 1 Y 3 Y 2 AS 45º AE lower stock prices higher stock prices AD lower stock prices AD P 1 P 2

The Wealth Effect and Equilibrium GDP Stock prices Autonomous consumption spending Both real GDP and price level Household wealth Multiplier effect

The Wealth Effect and Equilibrium GDP Changes in stock prices - through the wealth effect - cause both equilibrium GDP and the price level to move in the same direction. An increase in stock prices will raise equilibrium GDP and the price level.An increase in stock prices will raise equilibrium GDP and the price level. A decrease in stock prices will decrease both equilibrium GDP and the price level.A decrease in stock prices will decrease both equilibrium GDP and the price level.

The Wealth Effect and Equilibrium GDP Rapid increases in stock prices can cause significant positive demand shocks to the economy, shocks that policy makers cannot ignore. Rapid decreases in stock prices can cause significant negative demand shocks to the economy, which would be a major concern for policy makers.

How the Economy Affects The Stock Market: Expansion Real GDP Expected future profits Current profits Demand curves for stocks shift rightward Current stock prices

How the Economy Affects The Stock Market: Recession Real GDP Expected future profits Current profits Demand curves for stocks shift leftward Current stock prices

How the Economy Affects The Stock Market In the typical expansion, higher profits and stockholder optimism cause stock prices to rise. In the typical recession, lower profits and stockholder pessimism cause stock prices to fall.

What Happens When Things Change? A Shock to the EconomyA Shock to the Economy A Shock to the Economy and the Stock Market: The High-Tech Boom of the 1990sA Shock to the Economy and the Stock Market: The High-Tech Boom of the 1990s A Shock to the Economy and the Stock Market: The High-Tech Bust of 2000 and 2001A Shock to the Economy and the Stock Market: The High-Tech Bust of 2000 and 2001 The Fed and the Stock MarketThe Fed and the Stock Market

What Happens When Things Change?

A Shock to the Economy Real GDP Government purchases

A Shock to the Economy Real GDP Corporate profits Expected future profits

A Shock to the Economy Stock prices Real GDP Autonomous consumption spending

A Shock to the Economy When we include the effects of the stock market, the expenditure multiplier is larger. An increase in spending that increases real GDP will also cause stock prices to rise,also cause stock prices to rise, causing still greater increases in real GDP.causing still greater increases in real GDP.

A Shock to the Economy A decrease in spending that causes real GDP to fall will also cause stock prices to fall,also cause stock prices to fall, causing still greater decreases in real GDP.causing still greater decreases in real GDP.

The High-Tech Boom of the 1990s Mid-1999: Fed thought wealth effect would overheat the economy if nothing doneMid-1999: Fed thought wealth effect would overheat the economy if nothing done From June 1999 through May 2000:From June 1999 through May 2000: –Fed raised target for the Fed funds rate six times

The High-Tech Bust of 2000 and 2001 Market began to decline in early 2000Market began to decline in early 2000 Investment rush of the 1990s endedInvestment rush of the 1990s ended –firms caught up to new technology –investment spending decreased –recession began –stock prices fell

The High-Tech Bust of 2000 and 2001 Change in expectations about futureChange in expectations about future –companies went bankrupt –optimism about future profits shifted to pessimism –share prices fell

The High-Tech Bust of 2000 and 2001 Consumption spending remained strong due toConsumption spending remained strong due to –forces other than the drop in share prices –Fed interest rate reductions

The Fed and the Stock Market Technological changes of the 1990s: shock to both the stock market and the economy.Technological changes of the 1990s: shock to both the stock market and the economy. Fed concern: the market was experiencing a speculative bubbleFed concern: the market was experiencing a speculative bubble

The Fed and the Stock Market a a a Real GDP Price Level Y 1 Y 2 (a) P 1 P 2 AD 2 1 AS 1 A (b) Real GDP Price Level P 1 P 2 Y 1 Y 2 AS 1 Wealth effect of rising stock prices shifts AD rightward, raising real GDP and the price level AS 2 AD 1 2 A P 3 correcting mechanism If output exceeds potential, the self- will raise the price level further B C B

The Fed and the Stock Market a a a Unemployment Rate Inflation Rate 4%5% 2.5% 5.0% 1.5% But if the natural rate is above 4% the Phillips Curve will shift upward and the Fed must choose between higher inflation … … or recession Unemployment Rate Inflation Rate 4% 2.5% U N ? If the natural rate of unemployment is 4%, the Fed can keep the economy at point A in the long run PC 21 1 A D B C A U N ? (a)(b)