Transcript UT Stock Market & the Macroeconomy

Using All the Theory:
The Stock Market and the
Macroeconomy
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
The Stock Market and the
Macroeconomy
• In December 1996, Alan Greenspan—the chair of the
Federal Reserve Board—uttered two sentences that
caught world’s attention
– “How do we know when irrational exuberance has unduly
escalated asset values which then become the subject of
unexpected and prolonged contractions…?
– And how do we factor that assessment into monetary policy?”
• Greenspan was referring to rapid rise in stock prices that
had occurred over previous several years
• Everyone agreed that Greenspan’s remarks had been
designed to bring down stock prices and that he had
succeeded somewhat
– But this effort to “talk down the market” brought a wave of criticism
in business and media circles
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The Stock Market and the
Macroeconomy
• Flash forward to September 17, 2001
– First day of trading after stock market had been closed for a week
following terrorist attacks of September 11
• Alan Greenspan—still chair of Federal Reserve—watched
market with deep concern that week
– When Congress called him to testify, they hoped he would have
something encouraging to say
– He reassured nation there was no need for long-term pessimism
• In following days, market began to rise—slowly at first,
then more rapidly
– No one doubted that Greenspan’s reassuring words had helped to
turn the tide
• He was once again trying to influence stock prices
• This time, no one complained
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Basic Background
• Most basic question of all
– What is a share of stock?
• A private financial asset, like a corporate bond
• Important difference between stocks and bonds
– When a corporation issues a bond, it is borrowing funds
• Bond is a promise to pay back loan
– When a firm issues new shares of stock—in what is called a public
offering—sale of stock generates funds for firm
• A firm is still concerned about the price of its previously
issued shares for two reasons
– Firm’s owners—its stockholders—want high share prices because
that is price they can sell at
• Price of previously issued shares has an important impact
on firms that are planning new public offerings
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Why Do People Hold Stock?
• Stock ownership in United States is growing rapidly
• Why do so many individuals choose to hold their wealth in stocks?
– When you own a share of stock, you own part of the corporation
– Fraction of corporation that you own is equal to fraction of company’s total
stock that you own
• In practice most firms do not pay out all of their profit to shareholders
• Aside from dividends, a second—and usually more important—reason
that people hold stocks is that they hope to enjoy capital gains
• Some stocks pay no dividends at all, because management believes
stockholders are best served by reinvesting all profits within the firm so
that future profits will be even higher
• Over past century, corporate stocks have generally been a good
investment
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Tracking the Stock Market
• In United States, financial markets are so important that
stock and bond prices are monitored on a continuous
basis
• Media keeps a close watch on many stock market indices
or averages
– Oldest and most popular average
• Dow Jones Industrial Average (DJIA)
– 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
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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
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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 298 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 $60 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 $60—where the supply and demand curves
intersect—are people satisfied holding number of shares they are actually
holding
• Stocks achieve their equilibrium prices almost instantly
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Figure 1: The Market For Shares of
Fedex Corporation
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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
• But 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
• New information that decreases expectations of future profits will shift demand
curves leftward
– 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
– Any news that suggests an economic slowdown or a coming recession shifts demand
curves for most stocks leftward
– 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)
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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
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Figure 2: Shifts in the Demand for
Shares Curve
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Figure 3: The Two-Way Relationship Between
The Stock Market and the Economy
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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
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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)
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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
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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
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Figure 4: The Effect of Higher Stock
Prices on the Economy
(a)
(b)
Price
Level
Aggregate
Expenditure
AS
AE higher stock
prices
AE lower stock
prices
P2
P1
AD higher stock
prices
AD lower stock
45
prices
Y1
Y2
Real GDP
Y1
Y3 Y2
Real GDP
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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)
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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
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Figure 5: Three Types of Shocks
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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
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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
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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
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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
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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
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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
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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
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Figure 6: The Fed’s Problem In
2000: An AS-AD View
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Figure 7: The Fed’s Problem in
2000: A Phillips Curve View
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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?
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