Stock Market and Macroeconomy

Share of stock is a private financial asset, like a corporate bondBoth 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 elseVirtually all the shares traded in the stock market are previously issued- trading doesn’t involve the firm that issued the stock

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??

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

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

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

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

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

Figure 1: The Market For Shares of Fedex Corporation

Number of Shares

Price per Share

E

S

$120

90

60

D

302 million

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)

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

Figure 2a: Shifts in the Demand for Shares Curve

Number of Shares

Price per Share

S

$75

60

D2D1

(a)

298 million

The demand curve shifts rightward when new information causes expectations of:• higher future profits• economic expansion• lower interest rates

Figure 2b: Shifts in the Demand for Shares Curve

45

D3

Number of Shares

Price per Share

S

60

D1

298 million

(b)

The demand curve shifts leftward when new information causes expectations of:• lower future profits• recession• higher interest rates

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

Stock Market Macroeconomy

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

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)

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

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

Figure 4: The Effect of Higher Stock Prices on the Economy

(a) (b)

Y1 Y2Real GDP

Ag

gre

gat

e E

xpen

dit

ure

AEhigher stock prices

Real GDP

Price Level

Y1 Y3 Y2

AS

45°

AElower stock prices

ADhigher stock prices

ADlower stock prices

P1

P2

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)

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

Figure 5: Three Types of Shocks

Shock to bothstock market andmacroeconomy

Shock tomacroeconomy

Shock tostock market

Stock Market Macroeconomy

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

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

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

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

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

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

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

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

Real GDP

Price Level

Y1 Y2

(a)

P1 AD2A

BP2

AD1

AS AS1

AS2

A AD2

AD1

(b)

Real GDP

P1

P2

Y1 Y2

B

CP3

Price Level

If output exceeds potential, the self-correcting mechanism will raise the price level further

Wealth effect of rising stock prices shifts AD rightward, raising real GDP and the price level

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

A

C

B

D

4%5%

2.5%

5.0%

1.5%

PC1 PC2

. . . or recession

Unemployment Rate

InflationRate

A

4%

2.5%

PC1

UN?

(a) (b)Inflation

RateIf the natural rate of unemployment is 4%, the Fed can keep the economy at point A in the long run

Unemployment Rate

UN?

But if the natural rate is above 4% the Phillips curve will shift upward and the Fed must choose between higher inflation . . .

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?