1. ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Using All the Theory: The Stock Market and the Macroeconomy

2. 2 In December 1996, Alan Greenspan—the chair of the Federal Reserve Board—uttered two sentences that caught world’s attention –“How do we know when irrational exuberance has unduly escalated asset values which then become the subject of unexpected and prolonged contractions…? –And how do we factor that assessment into monetary policy?” Greenspan was referring to rapid rise in stock prices that had occurred over previous several years Everyone agreed that Greenspan’s remarks had been designed to bring down stock prices and that he had succeeded somewhat –But this effort to “talk down the market” brought a wave of criticism in business and media circles

3. 3 The Stock Market and the Macroeconomy Flash forward to September 17, 2001 –First day of trading after stock market had been closed for a week following terrorist attacks of September 11 Alan Greenspan—still chair of Federal Reserve—watched market with deep concern that week –When Congress called him to testify, they hoped he would have something encouraging to say –He reassured nation there was no need for long-term pessimism In following days, market began to rise—slowly at first, then more rapidly –No one doubted that Greenspan’s reassuring words had helped to turn the tide He was once again trying to influence stock prices This time, no one complained

4. 4 Basic Background Most basic question of all –What is a share of stock? A private financial asset, like a corporate bond Important difference between stocks and bonds –When a corporation issues a bond, it is borrowing funds Bond is a promise to pay back loan –When a firm issues new shares of stock—in what is called a public offering—sale of stock generates funds for firm A firm is still concerned about the price of its previously issued shares for two reasons –Firm’s owners—its stockholders—want high share prices because that is price they can sell at Price of previously issued shares has an important impact on firms that are planning new public offerings

5. 5 Why Do People Hold Stock? Stock ownership in United States is growing rapidly Why do so many individuals choose to hold their wealth in stocks? –When you own a share of stock, you own part of the corporation –Fraction of corporation that you own is equal to fraction of company’s total stock that you own In practice most firms do not pay out all of their profit to shareholders Aside from dividends, a second—and usually more important—reason that people hold stocks is that they hope to enjoy capital gains Some stocks pay no dividends at all, because management believes stockholders are best served by reinvesting all profits within the firm so that future profits will be even higher Over past century, corporate stocks have generally been a good investment

6. 6 Tracking the Stock Market In United States, financial markets are so important that stock and bond prices are monitored on a continuous basis Media keeps a close watch on many stock market indices or averages –Oldest and most popular average Dow Jones Industrial Average (DJIA) –Another popular average Broader Standard & Poor’s 500 (S&P 500) –NASDAQ index tracks share prices of about 5,000 mostly newer companies whose shares are traded on NASDAQ stock exchange Often, stock market averages will rise and fall at the same time, sometimes by the same percentage In spite of falling stock prices in 2000 and 2001, the last decade was good for stocks

7. 7 Explaining Stock Prices—Step #1: Characterize The Market Price of a share of stock—like any other— is determined in a market We’ll characterize the market for a company’s shares as perfectly competitive –View stock market as a collection of individual, perfectly competitive markets for particular corporations’ shares

8. 8 Step #2: Find The Equilibrium Like all prices in competitive markets, stock prices are determined by supply and demand –However, in stock markets, supply and demand curves require careful interpretations Figure 1 presents a supply and demand diagram for shares of Fedex Corporation On any given day, number of Fedex shares in existence is just the number that the firm has issued previously –Just because 298 million shares of Fedex stock exist, that does not mean that this is the number of shares that people will want to hold People have different expectations about firm’s future profits –At any price other than $60 per share, number of shares people are holding (on the supply curve) will differ from number they want to hold (on the demand curve) –Only at equilibrium price of $60—where the supply and demand curves intersect—are people satisfied holding number of shares they are actually holding Stocks achieve their equilibrium prices almost instantly

9. 9 Figure 1: The Market For Shares of Fedex Corporation

10. 10 Step #3: What Happens When Things Change? Supply curve for a corporation’s shares shifts rightward whenever there is a public offering –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 demand curve But what causes these sudden changes in demand for a share of stock? In almost all cases, it is one or more of the following three factors –Changes in expected future profits of firm Any new information that increases expectations of firms’ future profits will shift demand curves of affected stocks rightward –Including announcements of new scientific discoveries, business developments, or changes in government policy New information that decreases expectations of future profits will shift demand curves leftward –Macroeconomic Fluctuations Any news that suggests economy will enter an expansion, or that an expansion will continue, will shift demand curves for most stocks rightward –Any news that suggests an economic slowdown or a coming recession shifts demand curves for most stocks leftward –Changes in the interest rate A rise (drop) in the interest rate in the economy will shift the demand curves for most stocks to the left (right)

11. 11 Step #3: What Happens When Things Change? Even expectations of a future interest rate change can shift demand curves for stocks Such an event occurred on February 27, 2002, when Fed Chair Greenspan announced that it appeared economy was recovering from its recession –News that causes people to anticipate a rise in interest rate will shift demand curves for stocks leftward Similarly, news that suggests a future drop in the interest rate will shift demand curves for stocks rightward

12. 12 Figure 2: Shifts in the Demand for Shares Curve

13. 13 Figure 3: The Two-Way Relationship Between The Stock Market and the Economy

14. 14 How the Stock Market Affects the Economy On October 19, 1987, there was a dramatic drop in the stock market –One that made decline on September 17, 2001 seem small by comparison –Dow Jones Industrial Average fell by 508 points—a drop of 23%— about $500 billion in household wealth disappeared Newscaster Sam Donaldson asked, “Mr. President, are you concerned about the drop in the Dow?” –As Reagan entered his helicopter, he smiled calmly and replied, “Why, no, Sam. I don’t own any stocks” –It was a curious exchange (perhaps Reagan was joking) Whatever Reagan’s intent, statement was startling –Because, in fact, stock market does matter to all Americans

15. 15 The Wealth Effect To understand how market affects economy, let’s run through following mental experiment –Suppose that, for some reason stock prices rise –When stock prices rise, so does household wealth What do households do when their wealth increases? –Typically, they increase their spending Link between stock prices and consumer spending is an important one, so economists have given it a name –Wealth effect Tells us that autonomous consumption spending tends to move in same direction as stock prices When stock prices rise (fall), autonomous consumption spending rises (falls)

16. 16 The Wealth Effect and Equilibrium GDP Autonomous consumption is a component of total spending Can summarize logic of the wealth effect Changes in stock prices—through the wealth effect—cause both equilibrium GDP and price level to move in same direction An increase in stock prices will raise equilibrium GDP and price level While a decrease in stock prices will decrease both equilibrium GDP and price level

17. 17 The Wealth Effect and Equilibrium GDP How important is wealth effect? –Economic research shows that marginal propensity to consume out of wealth is between 0.03 and 0.05 Change in consumption spending for each one-dollar rise in wealth As a rule of thumb, a 100-point rise in DJIA—which generally means a rise in stock prices in general—causes household wealth to rise by about $100 billion –This rise in household wealth will increase autonomous consumption spending by between $3 billion and $5 billion—we’ll say $4 billion Rapid increases in stock prices can cause significant positive demand shocks to economy, shocks that policy makers cannot ignore –Similarly, rapid decreases in stock prices can cause significant negative demand shocks to economy, which would be a major concern for policy makers

18. 18 Figure 4: The Effect of Higher Stock Prices on the Economy (a)(b) Y 1 Real GDP Aggregate Expenditure Real GDP Price Level Y 1 AS 45  AE lower stock prices AD P 1 lower stock prices Y 2 AE higher stock prices AD higher stock prices Y 3 P 2 Y 2

19. 19 How the Economy Affects the Stock Market Let’s look at the other side of the two-way relationship –How economy affects stock prices Many different types of changes in the overall economy can affect the stock market Let’s start by looking at the typical expansion –Real GDP rises rapidly over several years In typical expansion (recession), higher (lower) profits and stockholder optimism (pessimism) cause stock prices to rise (fall)

20. 20 What Happens When Things Change? Figure 5 illustrates three different types of changes we might explore –A change might have most of its initial impact on the overall economy, rather than the stock market –There might be a shock that initially affects stock market –Shock could have powerful, initial impacts on both stock market and overall economy

21. 21 Figure 5: Three Types of Shocks

22. 22 A Shock to the Economy Imagine that new legislation greatly increases government purchases –To equip public schools with more sophisticated telecommunications equipment, or to increase the strength of our armed forces –What will happen? Rise in government purchases will first increase real GDP through expenditure multiplier When we include effects of stock market, expenditure multiplier is larger –An increase in spending that increases real GDP will also cause stock prices to rise, causing still greater increases in real GDP –Similarly, a decrease in spending that causes real GDP to fall will also cause stock prices to fall, causing still greater decreases in real GDP This is one reason why stock prices are so carefully watched by policy makers, and matter for everyone –Whether they own stocks themselves or not

23. 23 A Shock To the Economy and the Stock Market: The High-Tech Boom of the 1990s 1990s—especially second half—saw dramatic rise in stock prices –Growth in real GDP averaged 4.2% annually from 1995-2000 In part, economic expansion and rise in stock prices were reinforcing –Each contributed to the other Internet had a direct impact on stock market through its effect on expected future profits of U.S. firms At the same time, technological revolution was having a huge impact on overall economy

24. 24 A Shock To the Economy and the Stock Market: The High-Tech Boom of the 1990s Faced with these demand shocks, Federal Reserve would ordinarily have raised its interest rate target to prevent real GDP from exceeding potential output Technological changes of 1990s were an example of a shock to both stock market and economy –Result was a market and an economy that were feeding on each other, sending both to new performance heights –Was this a good thing? Yes, and no In spite of all this good news, there were dark clouds on horizon

25. 25 A Shock to the Economy and the Stock Market: The High-Tech Bust of 2000 and 2001 The market—especially high-tech NASDAQ stocks— began to decline in early 2000 Both economy and market were being affected by several events discussed in earlier chapters of this book –During 1990s, there had been an investment boom Businesses rushed to incorporate the internet into factories, offices, and their business practices in general –Fed may have played a role as well Decline in investment—and the recession it caused—can be regarded as a shock to economy In addition, there was a direct shock to market –A change in expectations about the future Unfortunately, in late 2000 and early 2001, reality set in

26. 26 The Fed and the Stock Market Experience of late 1990s and early 2000s raised some important questions about relationship between Federal Reserve and stock market In 1995 and 1996, Greenspan and other Fed officials began to worry that share prices were rising out of proportion to the future profits they would be able to deliver to their owners In this view, market in late 1990s resembled stock market in 1920s, which is also often considered a bubble

27. 27 The Fed and the Stock Market In 1996, when Alan Greenspan first made his “irrational exuberance” speech, he seemed to side with those who believed that the stock market was in midst of a speculative bubble –Fed would be forced to intervene to prevent wealth effect—this time in a negative direction—from creating a recession Could Fed do so? –Probably In mid-1990s, Greenspan seemed to be trying to “talk the market down” by letting stockholders know that he thought share prices were too high –Implied threat If stocks rose any higher, Fed would raise interest rates and bring them down It didn’t work

28. 28 The Fed and the Stock Market Not only were Greenspan’s efforts to “talk the market down” unsuccessful, they were also widely criticized Greenspan seemed to change his tune as 1990s continued –By 1998, he had stopped referring to exuberance—rational or irrational As 1990s came to a close, and the stock market continued to soar, Fed faced a new problem –Wealth effect Figure 6 shows one way we can view Fed’s problem –With aggregate demand and supply curves Figure 6 is useful, but it has a serious limitation –Doesn’t take account of the rise in potential output But the Phillips curve can illustrate Fed’s goal more easily –To keep inflation low and stable without needing corrective recessions, Fed strives to maintain unemployment at its natural rate

29. 29 Figure 6: The Fed’s Problem In 2000: An AS-AD View

30. 30 Figure 7: The Fed’s Problem in 2000: A Phillips Curve View

31. 31 The Fed and the Stock Market Might think Fed can estimate natural rate by a process of trial and error –Bring unemployment rate to a certain level (such as 4%) and see what happens to inflation Unfortunately, things are not so simple –Fed looks ahead and determines whether current economic conditions are likely to raise inflation rate in the future That is just what Fed did beginning in mid-1999 By raising interest rates to rein in the economy, Fed also brought down stock prices –By slowing economic growth and growth in profits –Through direct effect of higher interest rates on stocks By 2001, high-tech bust, recession of 2001, and attacks of September 11 brought criticism to an end As the economy began a slow expansion, in 2002 and early 2003, Fed kept the interest rate low –Unresolved question will surface again Who should be setting the general level of share prices—millions of stockholders who buy and sell shares, or Federal Reserve?