1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 16 Chapter The Stock Market and the Economy

2. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 33 Chapter Outline 16 The Stock Market and the Economy Stocks and Bonds Bonds Stocks Determining the Price of a Stock The Stock Market Since 1948 Stock Market Effects on the Economy The Crash of October 1987 The Boom of 1995–2000 Fed Policy and the Stock Market The Post-Boom Economy

3. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 33 STOCKS AND BONDS BONDS bond A document that formally promises to pay back a loan under specified terms, usually over a specific time period.

4. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 33 Fill in the blanks. Firms borrow funds by issuing ____________, and pay interest to firms and households that ____________ their debt. a.stock; purchase b.stock; sell c.bonds; purchase d.bonds; sell

5. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 33 Fill in the blanks. Firms borrow funds by issuing ____________, and pay interest to firms and households that ____________ their debt. a.stock; purchase b.stock; sell c.bonds; purchase d.bonds; sell

6. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 33 STOCKS AND BONDS STOCKS stock A certificate that certifies ownership of a certain portion of a firm. capital gain An increase in the value of an asset. realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it.

7. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 33 STOCKS AND BONDS 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.

8. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 33 When does a company earn proceeds from the sale of stock? a.Only when it first issues the stock. b.When its shares are trade openly on private stock markets. c.Anytime the stock price goes up. d. All of the above.

9. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 33 When does a company earn proceeds from the sale of stock? a.Only when it first issues the stock. b.When its shares are trade openly on private stock markets. c.Anytime the stock price goes up. d. All of the above.

10. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 33 THE STOCK MARKET SINCE 1948 Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance. NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System.

11. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 33 THE STOCK MARKET SINCE 1948 Standard and Poor’s 500 (S&P 500) 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.

12. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 33 From a macroeconomic perspective, which stock price index is a better measure of the market value of firms in the economy? a.The NASDAQ Stock Market. b.The Dow Jones Industrial Average. c.The S&P 500. d. Any of the above.

13. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 33 From a macroeconomic perspective, which stock price index is a better measure of the market value of firms in the economy? a.The NASDAQ Stock Market. b.The Dow Jones Industrial Average. c.The S&P 500. d. Any of the above.

14. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 33 THE STOCK MARKET SINCE 1948 FIGURE 16.1The S&P 500 Stock Price Index, 1948 I–2005 II

15. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 33 THE STOCK MARKET SINCE 1948 FIGURE 16.2Ratio of After-Tax Profits to GDP, 1948 I–2005 II

16. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 33 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.

17. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 33 How does a change in stock price affect a firm’s decision to invest? a.A firm is likely to undertake more investment projects the higher its stock price. b.The cost of an investment project is higher the higher the price of the stock, so the firm is likely to invest less. c.Investment decisions are independent (not affected by) changes in the stock price of a firm. d.Investment consists of buying stocks and bonds, so the firm does not engage in investment itself.

18. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 33 How does a change in stock price affect a firm’s decision to invest? a.A firm is likely to undertake more investment projects the higher its stock price. b.The cost of an investment project is higher the higher the price of the stock, so the firm is likely to invest less. c.Investment decisions are independent (not affected by) changes in the stock price of a firm. d.Investment consists of buying stocks and bonds, so the firm does not engage in investment itself.

19. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 33 STOCK MARKET EFFECTS ON THE ECONOMY The value of stocks in the United States fell by about a trillion dollars between August 1987 and the end of October 1987. If the multiplier is 1.4, the total decrease in GDP would be about 1.4 x $40 billion = $56 billion, or about 1.4 percent of GDP. 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. THE CRASH OF OCTOBER 1987

20. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 33 STOCK MARKET EFFECTS ON THE ECONOMY THE BOOM OF 1995–2000 FIGURE 16.3Personal Saving Rate, 1995 I–2002 III

21. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.4Investment-Output Ratio, 1995 I–2002 III

22. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.5Ratio of Federal Government Budget Surplus to GDP, 1995 I–2002 III

23. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.6Growth Rate of Real GDP, 1995 I–2002 III

24. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.7The Unemployment Rate, 1995 I–2002 III

25. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.8Inflation Rate, 1995 I–2002 III

26. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 33 STOCK MARKET EFFECTS ON THE ECONOMY FIGURE 16.93-Month Treasury Bill Rate, 1995 I–2002 III

27. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 33 The effects of the stock market on the economy can be described as follows: a.Higher stock prices increase household wealth and consumption, but only in the future; therefore, current consumption, output, income, and aggregate spending are not affected. b.Higher stock prices decrease household wealth, causing a decrease in current and future consumption, and a decrease in output and income. c.Higher stock prices increase household wealth, causing an increase in current and future consumption, as well as higher output, income, and aggregate spending. d.Stock prices are not a determinant of household wealth; thus, changes in stock prices do not affect consumption, output, income, or aggregate spending.

28. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 33 The effects of the stock market on the economy can be described as follows: a.Higher stock prices increase household wealth and consumption, but only in the future; therefore, current consumption, output, income, and aggregate spending are not affected. b.Higher stock prices decrease household wealth, causing a decrease in current and future consumption, and a decrease in output and income. c.Higher stock prices increase household wealth, causing an increase in current and future consumption, as well as higher output, income, and aggregate spending. d.Stock prices are not a determinant of household wealth; thus, changes in stock prices do not affect consumption, output, income, or aggregate spending.

29. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 33 STOCK MARKET EFFECTS ON THE ECONOMY The Fed cares about the stock market to the extent that the stock market affects the things that it ultimately cares about, namely, output, unemployment, and inflation. FED POLICY AND THE STOCK MARKET

30. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 33 STOCK MARKET EFFECTS ON THE ECONOMY Both stock market wealth and housing wealth have important effects on the economy. THE POST-BOOM ECONOMY

31. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 33 After the stock market boom of the last half of the 1990s ended, what happened? a.There was a correction that led to a less expansionary economy. b.There was a correction in stock values that led to a large fall in household wealth. c.The economy was very sluggish, even at a time of very expansionary monetary and fiscal policy. d. All of the above.

32. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 33 After the stock market boom of the last half of the 1990s ended, what happened? a.There was a correction that led to a less expansionary economy. b.There was a correction in stock values that led to a large fall in household wealth. c.The economy was very sluggish, even at a time of very expansionary monetary and fiscal policy. d. All of the above.

33. CHAPTER 16: The Stock Market and the Economy © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 33 bond capital gain Dow Jones Industrial Average NASDAQ Composite realized capital gain Standard and Poor’s 500 (S&P 500) stock REVIEW TERMS AND CONCEPTS