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The Stock Market and the Economy Introduction to Economics Johnstown High School Mr. Cox How the Stock Market Affects the Economy On October 19, 1987, there was a dramatic drop in the stock market One that made declines in 2001 and 2008 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 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