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Using All the Theory: Using All the Theory: The Stock Market and The Stock Market and
the Macroeconomythe Macroeconomy
© 2003 South-Western/Thomson Learning© 2003 South-Western/Thomson Learning
Basic BackgroundBasic Background
•Why Do People Hold Why Do People Hold Stock?Stock?
•Tracking the Stock MarketTracking the Stock Market
Basic BackgroundBasic Background
A share of stock is a private A share of stock is a private financial asset that is a financial asset that is a
share of share of ownership ownership in a in a corporation.corporation.
Why Do People Hold Why Do People Hold Stock?Stock?
Individuals hold some of their Individuals hold some of their wealth in stocks in order to wealth in stocks in order to receive the part of corporate receive the part of corporate profits that is distributed as profits that is distributed as
dividends.dividends.
A second - and usually more A second - and usually more important - reason that people important - reason that people hold stocks is that they hope to hold stocks is that they hope to
enjoy enjoy capital gains.capital gains.
Tracking the Stock Tracking the Stock MarketMarket
Stock and bond prices are Stock and bond prices are monitored on a continuous basis.monitored on a continuous basis.
In addition to monitoring In addition to monitoring individual stocks, the media keep individual stocks, the media keep
a close watch on many stock a close watch on many stock market indices or averages.market indices or averages.
Explaining Stock Explaining Stock PricesPrices
The stock market is a The stock market is a collection of individual, collection of individual, perfectly competitive perfectly competitive markets for particular markets for particular corporations’ shares.corporations’ shares.
Explaining Stock PricesExplaining Stock Prices
Stockholders are concerned about Stockholders are concerned about both the rate of return and the both the rate of return and the
risk associated with stocks. risk associated with stocks.
In practice, they try to allocate In practice, they try to allocate their total wealth among a their total wealth among a
collection of assets - including collection of assets - including stocks - that strikes the right stocks - that strikes the right
balance between risk and return.balance between risk and return.
Explaining Stock PricesExplaining Stock Prices
Number of Shares
Priceper Share
E
S
$90
60
30
D
298 million
Explaining Stock Prices Explaining Stock Prices
The supply curve for a stock The supply curve for a stock tells us the quantity of shares tells us the quantity of shares in existence at any moment in in existence at any moment in
timetime. .
This is the number of shares This is the number of shares that people are that people are actually actually
holdingholding..
Explaining Stock Prices Explaining Stock Prices
The desire to hold a stock is The desire to hold a stock is given by the downward-given by the downward-sloping demand curve.sloping demand curve.
Explaining Stock Prices Explaining Stock Prices
Only at the Only at the equilibrium price - equilibrium price - where the supply and demand where the supply and demand curves intersect - are people curves intersect - are people
satisfied holding the number of satisfied holding the number of shares they are shares they are actually actually
holding.holding.
Explaining Stock Prices Explaining Stock Prices
The changes we observe in a The changes we observe in a stock’s price - over a few stock’s price - over a few
minutes, a few days, or a few minutes, a few days, or a few years - are virtually always years - are virtually always
caused by shifts in the demand caused by shifts in the demand curve.curve.
Explaining Stock Prices Explaining Stock Prices
Number of Shares
Priceper
Share
S
$75
60
(a) (b)
298 million
The demand curve shiftsrightward when newinformation causesexpectations of:• higher future profits• economic expansion• lower interest rates
Number of Shares
Priceper
Share
S
45
$60
298 million
The demand curve shiftsleftward when newinformation causesexpectations of:• lower future profits• recession• higher interest rates
D2
D1D1
D3
Explaining Stock PricesExplaining Stock Prices
Any new information that Any new information that increasesincreases expectations of expectations of
firms’ future profits - firms’ future profits - announcements of new announcements of new
scientific discoveries, business scientific discoveries, business developments, or changes developments, or changes
in government policy - will in government policy - will shift the demand curves of the shift the demand curves of the
affected stocks affected stocks rightwardrightward..
Explaining Stock PricesExplaining Stock Prices
New information that New information that decreasesdecreases expectations of expectations of
future profits will shift the future profits will shift the demand curves demand curves leftwardleftward..
Explaining Stock PricesExplaining Stock Prices
Any news that suggests the Any news that suggests the economy will economy will enter an enter an expansionexpansion, or that an , or that an
expansion will continue, will expansion will continue, will shift the demand curves for shift the demand curves for
most stocks most stocks rightwardrightward. .
Explaining Stock PricesExplaining Stock Prices
Any news that suggests an Any news that suggests an economic economic slowdown slowdown or a or a
coming coming recessionrecession shifts the shifts the demand curves for most stocks demand curves for most stocks
leftwardleftward..
Explaining Stock PricesExplaining Stock Prices
A A riserise in the interest rate in in the interest rate in the economy will shift the the economy will shift the
demand curves for most stocks demand curves for most stocks to the to the leftleft. .
A A dropdrop in the interest rate will in the interest rate will shift the demand curves for shift the demand curves for
most stocks to the most stocks to the rightright..
Explaining Stock PricesExplaining Stock Prices
News that causes people to News that causes people to anticipate a riseanticipate a rise in the interest in the interest
rate will shift the demand rate will shift the demand curves for stocks curves for stocks leftwardleftward. .
News that News that suggests a future suggests a future dropdrop in the interest rate will in the interest rate will shift the demand curves for shift the demand curves for
stocks stocks rightwardrightward..
The Stock Market The Stock Market and the Macroeconomyand the Macroeconomy
•How the Stock Market How the Stock Market Affects the EconomyAffects the Economy
•How the Economy Affects How the Economy Affects the Stock Marketthe Stock Market
The Stock Market The Stock Market and the Macroeconomyand the Macroeconomy
Stock Market Macroeconomy
How the Stock Market How the Stock Market Affects the EconomyAffects the Economy
•The Wealth EffectThe Wealth Effect
•The Wealth Effect and Equilibrium The Wealth Effect and Equilibrium GDPGDP
The Wealth EffectThe Wealth Effect
Autonomous consumption Autonomous consumption spending tends to move in spending tends to move in the same direction as stock the same direction as stock prices. prices.
• When stock prices rise, When stock prices rise, autonomous consumption autonomous consumption spending rises.spending rises.
• When stock prices fall, When stock prices fall, autonomous consumption autonomous consumption spending falls with it.spending falls with it.
The Wealth Effect and The Wealth Effect and Equilibrium GDPEquilibrium GDP
(a) (b)
Y1 Y2 Real GDP
AggregateExpenditure
AE higher stock prices
Real GDP
PriceLevel
Y1 Y3 Y2
AS
45º
AE lower stockprices
higher stock pricesAD
lower stock pricesAD
P1
P2
The Wealth Effect and The Wealth Effect and Equilibrium GDPEquilibrium GDP
Stock prices
Autonomous consumption spending
Both real GDP and price level
Household wealth
Multiplier
effect
The Wealth Effect and The Wealth Effect and Equilibrium GDPEquilibrium GDP
Changes in stock prices - Changes in stock prices - through the wealth effect - through the wealth effect - cause both equilibrium GDP cause both equilibrium GDP and the price level to move in and the price level to move in the same direction. the same direction.
• An increase in stock prices will An increase in stock prices will raise equilibrium GDP and the raise equilibrium GDP and the price level. price level.
• A decrease in stock prices will A decrease in stock prices will decrease both equilibrium GDP decrease both equilibrium GDP and the price level.and the price level.
The Wealth Effect and The Wealth Effect and Equilibrium GDPEquilibrium GDP
Rapid Rapid increasesincreases in stock prices in stock prices can cause significant positive can cause significant positive
demand shocks to the economy, demand shocks to the economy, shocks that policy makers shocks that policy makers
cannot ignore. cannot ignore.
Rapid Rapid decreasesdecreases in stock prices in stock prices can cause significant negative can cause significant negative
demand shocks to the economy, demand shocks to the economy, which would be a major concern which would be a major concern
for policy makers.for policy makers.
How the Economy How the Economy Affects The Stock Affects The Stock
Market: Market: ExpansionExpansion
Real GDP
Expected future profits
Current profits
Demand curves for stocks shift rightward
Current stock prices
How the Economy How the Economy Affects The Stock Affects The Stock Market: Market: RecessionRecession
Real GDP
Expected future profits
Current profits
Demand curves for stocks shift leftward
Current stock prices
How the Economy How the Economy Affects The Stock Affects The Stock
Market Market In the typical In the typical expansionexpansion, ,
higher profits and stockholder higher profits and stockholder optimism cause optimism cause stock prices to stock prices to
riserise. .
In the typical In the typical recessionrecession, lower , lower profits and stockholder profits and stockholder
pessimism cause pessimism cause stock prices stock prices to fallto fall..
What Happens What Happens When Things Change?When Things Change?•A Shock to the EconomyA Shock to the Economy
•A Shock to the Economy A Shock to the Economy and and the the Stock Market: The High-Tech Stock Market: The High-Tech
Boom of the 1990sBoom of the 1990s•A Shock to the Economy A Shock to the Economy and and the the Stock Market: The High-Tech Bust Stock Market: The High-Tech Bust
of 2000 and 2001of 2000 and 2001•The Fed and the Stock MarketThe Fed and the Stock Market
What Happens When What Happens When Things Change?Things Change?
Stock M arket
Shock to bothstock m arket andm acroeconom y
M acroeconom y
Shock tostock m arket
Shock tom acroeconom y
A Shock to the A Shock to the EconomyEconomy
Real GDP
Government purchases
A Shock to the A Shock to the EconomyEconomy
Real GDP
Corporate profits
Expected future profits
A Shock to the A Shock to the EconomyEconomy
Stock prices
Real GDP
Autonomous consumption spending
A Shock to the A Shock to the EconomyEconomy
When we include the effects of When we include the effects of the stock market, the the stock market, the expenditure multiplier is expenditure multiplier is larger. larger.
An increase in spending that An increase in spending that increases real GDP will increases real GDP will
• also cause stock prices to rise, also cause stock prices to rise, • causing still greater increases causing still greater increases
in real GDP.in real GDP.
A Shock to the A Shock to the EconomyEconomy
A decrease in spending that A decrease in spending that causes real GDP to fall will causes real GDP to fall will
• also cause stock prices to also cause stock prices to fall, fall,
• causing still greater causing still greater decreases in real GDP.decreases in real GDP.
The High-Tech The High-Tech Boom of the 1990sBoom of the 1990s
• Mid-1999: Fed thought Mid-1999: Fed thought wealth effect would overheat wealth effect would overheat the economy if nothing donethe economy if nothing done
• From June 1999 through From June 1999 through May 2000:May 2000:–Fed raised target for the Fed Fed raised target for the Fed funds rate funds rate sixsix times times
The High-Tech Bust The High-Tech Bust of 2000 and 2001of 2000 and 2001
• Market began to decline in Market began to decline in early 2000early 2000
• Investment rush of the Investment rush of the 1990s ended 1990s ended –firms caught up to new firms caught up to new technologytechnology–investment spending investment spending decreaseddecreased–recession beganrecession began–stock prices fellstock prices fell
The High-Tech Bust The High-Tech Bust of 2000 and 2001of 2000 and 2001
• Change in expectations Change in expectations about futureabout future–companies went bankruptcompanies went bankrupt–optimism about future optimism about future profits shifted to pessimismprofits shifted to pessimism–share prices fellshare prices fell
The High-Tech Bust The High-Tech Bust of 2000 and 2001of 2000 and 2001
• Consumption spending Consumption spending remained strong due toremained strong due to–forces other than the drop forces other than the drop in share pricesin share prices–Fed interest rate Fed interest rate reductionsreductions
The Fed and the Stock The Fed and the Stock MarketMarket
• Technological changes of Technological changes of the 1990s: shock to both the the 1990s: shock to both the stock market stock market and and the the economy.economy.
• Fed concern: the market was Fed concern: the market was experiencing a speculative experiencing a speculative bubblebubble
The Fed and the Stock The Fed and the Stock MarketMarket
Real GDP
PriceLevel
Y1 Y2
(a)
P1
P2
AD2
AD1
AS1
A
(b)
Real GDP
PriceLevel
P1
P2
Y1 Y2
AS1
Wealth effect of risingstock prices shifts ADrightward, raising realGDP and the price level
AS2
AD1
AD2A
P3
correcting mechanism
If output exceedspotential, the self-
will raise the pricelevel further
B
C
B
The Fed and the Stock The Fed and the Stock MarketMarket
Unemployment Rate
InflationRate
4% 5%
2.5%
5.0%
1.5%
But if the naturalrate is above 4%the Phillips Curvewill shift upwardand the Fed mustchoose betweenhigher inflation …
… orrecession
Unemployment Rate
InflationRate
4%
2.5%
UN?
If the natural rateof unemploymentis 4%, the Fed cankeep the economyat point A in thelong run
PC21PCPC1
AD
B
C
A
UN?
(a) (b)
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