Transcript Using the Theory

Economics: Principles and
Applications, 2e
by Robert E. Hall &
Marc Lieberman
© 2001 South-Western, a division of Thomson Learning
Using All the Theory:
The Stock Market and
the Macroeconomy
© 2001 South-Western, a division of Thomson Learning
Basic Background
•Why Do People Hold Stock?
•Tracking the Stock Market
© 2001 South-Western, a division of Thomson Learning
Basic Background
A share of stock is a private financial asset
that is a share of ownership in a corporation.
© 2001 South-Western, a division of Thomson Learning
Basic Background
Individuals hold some of their wealth in stocks in
order to receive the part of corporate profits that is
distributed as dividends. A second--and usually
more important--reason that people hold stocks is
that they hope to enjoy capital gains.
© 2001 South-Western, a division of Thomson Learning
Basic Background
In the United States, financial markets are so
important that stock and bond prices are monitored
on a continuous basis. In addition to monitoring
individual stocks, the media keep a close watch on
many stock market indices or averages.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
•Key Step #1: Characterize the Market
•Key Step #2: Identify the Goals and Constraints
•Key Step #3: Find the Equilibrium
•Key Step #4: What Happens When Things Change?
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
We will view the stock market as a collection
of individual, perfectly competitive markets
for particular corporations’ shares.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
Stockholders are concerned about both the rate of
return and the risk associated with stocks. In
practice, they try to allocate their total wealth
among a collection of assets--including stocks--that
strikes the right balance between risk and return.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
The supply curve for a stock tells us the
quantity of shares in existence at any moment
in time. This is the number of shares that
people are actually holding.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
The desire to hold a stock is given by the
downward-sloping demand curve.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
Only at the equilibrium price--where the
supply and demand curves intersect--are
people satisfied holding the number of shares
they are actually holding.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
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
the demand curve.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
Any new information that increases expectations of firms’
future profits--including announcements of new scientific
discoveries, business developments, or changes in
government policy--will shift the demand curves of the
affected stocks rightward. New information that decreases
expectations of future profits will shift the demand curves
leftward.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
Any news that suggests the economy will enter an
expansion, or that an expansion will continue, will shift the
demand curves for most stocks rightward. Any news that
suggests an economic slowdown or a coming recession
shifts the demand curves for most stocks leftward.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
A rise in the interest rate in the economy will shift
the demand curves for most stocks to the left.
Similarly, a drop in the interest rate will shift the
demand curves for most stocks to the right.
© 2001 South-Western, a division of Thomson Learning
Explaining Stock Prices
News that causes people to anticipate a rise in the
interest rate will shift the demand curves for stocks
leftward. Similarly, news that suggests a future drop
in the interest rate will shift the demand curves for
stocks rightward.
© 2001 South-Western, a division of Thomson Learning
The Stock Market
and the Macroeconomy
•How the Stock Market Affects the Economy
•How the Economy Affects the Stock Market
© 2001 South-Western, a division of Thomson Learning
The Stock Market
and the Macroeconomy
The wealth effect tells us that autonomous consumption
spending tends to move in the same direction as stock
prices. When stock prices rise, autonomous consumption
spending rises; when stock prices fall, autonomous
consumption spending falls with it.
© 2001 South-Western, a division of Thomson Learning
The Stock Market
and the Macroeconomy
Changes in stock prices--through the wealth effect--cause
both equilibrium GDP and the price level to move in the
same direction. That is, an increase in stock prices will
raise equilibrium GDP and the price level, while a decrease
in stock prices will decrease both equilibrium GDP and the
price level.
© 2001 South-Western, a division of Thomson Learning
The Stock Market
and the Macroeconomy
Rapid increases in stock prices can cause significant
positive demand shocks to the economy, shocks that policy
makers cannot ignore. Similarly, rapid decreases in stock
prices can cause significant negative demand shocks to the
economy, which would be a major concern for policy
makers.
© 2001 South-Western, a division of Thomson Learning
The Stock Market
and the Macroeconomy
In the typical expansion, higher profits and
stockholder optimism cause stock prices to rise. In
the typical recession, lower profits and stockholder
pessimism cause stock prices to fall.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
•A Shock to the Economy
•A Shock to the Economy and the Stock Market: The 1990s
•The Fed’s Dilemma in the Late 1990s and Early 2000
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
When we include the effects of the stock market,
the 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.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
A decrease in spending that causes real GDP
to fall will also cause stock prices to fall,
causing still greater decreases in real GDP.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
The technological changes of the 1990s were
an example of a shock to both the stock
market and the economy.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
Around 1995 and 1996, some officials at the U.S.
Federal Reserve began to worry that share prices
were rising out of proportion to the future profits
they would be able to deliver to their owners.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
The Fed was worried that the market was
experiencing a speculative bubble--a frenzy of
buying that encouraged people to buy stocks and
drive up their price just because their prices were
rising.
© 2001 South-Western, a division of Thomson Learning
What Happens
When Things Change?
Beginning in mid-1999, Fed officials believed that
the wealth effect would overheat the economy if
nothing were done. From June 1999 through May
2000, the Fed raised its target for the federal funds
rate six times.
© 2001 South-Western, a division of Thomson Learning