1. Stock Market and Macroeconomy
Share of stock is a private financial asset, like a
corporate bond
Both are issued by corporations to raise funds, both
offer future payments to their owners
but what is the main difference between these
two?
When a firm issues new shares of stock- called
public offerings – sale of which generates funds for
the firm- newly issued shares can be sold to
someone else
Virtually all the shares traded in the stock market
are previously issued- trading doesn’t involve the
firm that issued the stock
2. Contd
But why the firm still concerned about the price
of its previously issued share?
- first, the firm’s owners-its stockholders-want
high share prices because that is the price they
can sell at
-second, previously issued shares are perfect
substitute of new public offerings –
------------therefore, the firm cannot expect to
receive higher price for its new shares than the
going price on its old shared
---what is the result then??
3. Contd..
In 1983, only 19 percents of Americans owned share of
stocks either directly or through mutual funds(?) – in 2003,
almost 50% American owned stock
You own a share of stock implies you own part of the
corporation-own a fraction of the company’s total stock
you are entitled to a particular percent of the firm’s after tax
profit
However, firms do not pay all their after-tax profit to share
holders- some is kept as retained earnings for later use of
the firm
The part of profit distributed to share holders is called
dividends
Aside from dividends, usually more important reason to
holding stocks is to enjoy capital gains – return someone
gets when they sell a stock at a higher price than they paid
for it
4. Tracking the stock market
Financial market is so important that stocks and
bonds are monitored on a continuous basis
You can find out the value of a stock instantly
just by checking with a broker or logging onto a
website
Daily news paper or specialized financial
publication such as Wall Street Journal or
Financial Times report daily information
In addition to that, there are many stock market
indices
5. Tracking..
Oldest and most popular average
Dow Jones Industrial Average (DJIA)-tracks
prices of 30 of the largest companies
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
6. 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
Many buyers and sellers
Virtually free entry
7. 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 302 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 $90 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 $90— people satisfied holding number of
shares they are actually holding
Stocks achieve their equilibrium prices almost instantly
8. Figure 1: The Market For Shares of
Fedex Corporation
Price per Share S
$120
90 E
60
D
302 million Number of Shares
9. 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
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
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
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)
10. 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
11. Figure 2a: Shifts in the Demand
for Shares Curve
(a)
Price S The demand curve shifts rightward when
per Share new information causes expectations of:
• higher future profits
• economic expansion
$75 • lower interest rates
60
D2
D1
298 million Number of Shares
12. Figure 2b: Shifts in the Demand
for Shares Curve
(b)
Price S The demand curve shifts leftward when
per Share new information causes expectations of:
• lower future profits
• recession
• higher interest rates
60
45
D1
D3
298 million Number of Shares
13. Figure 3: The Two-Way Relationship Between
The Stock Market and the Economy
Stock Market Macroeconomy
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. 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. 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. 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. Figure 4: The Effect of Higher
Stock Prices on the Economy
(a) (b)
Price AS
Aggregate Expenditure
Level
AEhigher stock prices
AElower stock prices
P2
P1
ADhigher stock prices
45° ADlower stock prices
Y1 Y2 Real GDP Y1 Y3 Y2 Real GDP
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. 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. Figure 5: Three Types of
Shocks
Shock to Shock to
stock market macroeconomy
Stock Market Macroeconomy
Shock to both
stock market and
macroeconomy
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. 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. 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. 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. 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. 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. 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. Figure 6: The Fed’s Problem In
2000: An AS-AD View
(a) (b)
If output exceeds potential, the
Price Wealth effect of rising self-correcting mechanism will
Price AS2
Level stock prices shifts AD raise the price level further
Level
rightward, raising real AS1
AS
GDP and the price level
C
P3
B
P2 P2 B
A
P1 AD2 P1 A AD2
AD1 AD1
Y1 Y2 Real GDP Y1 Y2 Real GDP
30. Figure 7: The Fed’s Problem in
2000: A Phillips Curve View
(a) (b) But if the natural
Inflation Inflation rate is above 4%
Rate If the natural rate of Rate
unemployment is 4%, the C the Phillips curve
Fed can keep the economy 5.0% will shift upward
at point A in the long run and the Fed must
choose between
higher inflation . . .
A D
2.5% A 2.5%
. . . or recession
B
1.5%
PC1 PC1 PC
2
4% Unemployment 4% 5% Unemployment
Rate Rate
UN ? UN?
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?