Transcript Lecture Notes Stock Market and Macroeconomy

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
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
Price per Share
S
$120
90
E
60
D
302 million
Number of Shares
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


Macroeconomic Fluctuations


Including announcements of new scientific discoveries, business
developments, or changes in government policy
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
(a)
Price
per Share
S
$75
The demand curve shifts rightward when
new information causes expectations of:
• higher future profits
• economic expansion
• lower interest rates
60
D2
D1
298 million
Number of Shares
Figure 2b: Shifts in the Demand
for Shares Curve
(b)
Price
per Share
S
The demand curve shifts leftward when
new information causes expectations of:
• lower future profits
• recession
• higher interest rates
60
45
D1
D3
298 million
Number of Shares
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
Aggregate Expenditure
(a)
(b)
AS
Price
Level
AEhigher stock prices
AElower stock prices
P2
P1
ADhigher stock prices
ADlower stock prices
45°
Y1
Y2
Real GDP
Y1 Y3 Y2
Real GDP
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
stock market
Shock to
macroeconomy
Stock Market
Macroeconomy
Shock to both
stock market and
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
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
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
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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

With aggregate demand and supply curves

Doesn’t take account of the rise in potential output

To keep inflation low and stable without needing corrective
recessions, Fed strives to maintain unemployment at its
natural rate
Figure 6 shows one way we can view Fed’s problem
Figure 6 is useful, but it has a serious limitation
But the Phillips curve can illustrate Fed’s goal more easily
Figure 6: The Fed’s Problem In
2000: An AS-AD View
(a)
(b)
If output exceeds potential, the
self-correcting
AS2
Price mechanism will
raise the
price level further
Level
Price Wealth effect of rising
Level stock prices shifts AD
rightward, raising real
AS
GDP and the price level
AS1
P3
B
P2
P1
C
P2
A
AD2
B
AD1
Y1
Y2
Real GDP
AD2
A
P1
AD1
Y1
Y2 Real GDP
Figure 7: The Fed’s Problem in
2000: A Phillips Curve View
(a)
Inflation
Rate
2.5%
(b)
If the natural rate of
unemployment is 4%, the
Fed can keep the economy
at point A in the long run
Inflation
Rate
5.0%
A
2.5%
1.5%
PC1
4% Unemployment
Rate
UN?
C
A
But if the natural
rate is above 4%
the Phillips curve
will shift upward
and the Fed must
choose between
higher inflation . . .
D
B
. . . or recession
PC1 PC
2
4% 5% Unemployment
Rate
UN?
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

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
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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

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By slowing economic growth and growth in profits
Through direct effect of higher interest rates on stocks

Unresolved question will surface again
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

Who should be setting the general level of share prices—
millions of stockholders who buy and sell shares, or Federal
Reserve?