Transcript The Stock Market and the Economy

CHAPTER
16
The Stock Market
and the Economy
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 16: The Stock Market and the Economy
The Stock Market
and the Economy
• As recently as a decade ago
macroeconomics could ignore the
stock market because its impact on
the economy was small
• The stock market boom of the last
half of the 1990s had a large impact
on the economy.
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C H A P T E R 16: The Stock Market and the Economy
Business Investment and Finance
• To make a large purchase, a firm can borrow the funds from
a bank, but it can also issue a bond.
• 2. Investment projects are usually very large, often
requiring external financing.
• a. Internal financing means payment out of retained
earnings.
• b.
External financing
• 3.
Types of external financing
• a.
Bank loans
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b. Issuing bonds
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c. Issuing stock
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C H A P T E R 16: The Stock Market and the Economy
Stocks and Bonds
• A bond is a document that promises to pay back
a loan under specified terms and a given period
of time.
• Bonds have several properties:
• Face value, or the amount the buyer agrees to lend to
the bond issuer.
• Maturity date, or the date when the funds are paid
back to the lender (although the lender may sell the
bond before maturity).
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C H A P T E R 16: The Stock Market and the Economy
Bonds
• A fixed payment, many bonds make
regular payments once or twice a
year. These payments are called
coupon payments. The coupon is a
fixed dollar amount specified in the
bond covenant.
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C H A P T E R 16: The Stock Market and the Economy
Bonds
15-yr. Bond
Face Value: $10,000
Coupon rate: 10%
Bank Account
requires only: $5,000
with interest rate of 20%
Yearly payment of
$1,000
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To obtain same yearly
payment of $1,000
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C H A P T E R 16: The Stock Market and the Economy
Stocks
• A stock is a certificate that certifies
ownership of a certain portion of a
firm.
• When a firm issues new shares of
stock, it does not add to its debt.
Instead, it brings in additional
“owners” who supply it with funds.
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C H A P T E R 16: The Stock Market and the Economy
Stocks
• Stockholders have a right to select
the management of the firm and to
share in its profits.
• Unlike bonds or direct borrowing,
stocks do not promise a fixed annual
payment. Returns depend on
company performance. If profits are
high, the firm may pay dividends.
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C H A P T E R 16: The Stock Market and the Economy
Stocks
• A capital gain is an increase in the
value of an asset.
• A realized capital gain occurs when
the owner of an asset actually sells it
for more than he paid for it.
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C H A P T E R 16: The Stock Market and the Economy
Stocks
• Most stocks bought and sold on the
stock market daily are not newly
issued but issued long ago, when the
firm “goes public.”
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C H A P T E R 16: The Stock Market and the Economy
Determining the Price of a Stock
• Things that are likely to affect the
price of a stock include:
• What people expect its future dividends
will be
• When the dividends are expected to be
paid
• The amount of risk involved
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C H A P T E R 16: The Stock Market and the Economy
Determining the Price of a Stock
• The amount by which future
dividends are discounted depends
on the interest rate. The larger the
interest rate, the more will expected
future dividends be discounted.
Interest rate
10%
Amount today
Pays one year
from now
$100 $104.76
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$110
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5%
$110
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C H A P T E R 16: The Stock Market and the Economy
Determining the Price of a Stock
• The amount by which future
dividends are discounted is greater
when the possibility of obtaining
dividends from a firm is more
uncertain.
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C H A P T E R 16: The Stock Market and the Economy
Determining the Price of a Stock
• Thus we can say that the price of a
stock should equal the discounted
value of its expected future
dividends, where the discount factors
depend on the interest rate and risk.
• Announcements of higher expected
future dividends or perceived lower
risk should increase the firm’s stock
price.
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C H A P T E R 16: The Stock Market and the Economy
Determining the Price of a Stock
• The price of a stock may also be
driven up not by the discounted
value of expected future dividends,
but by people’s views of what others
will pay for the stock in the future.
• One might call this a bubble because
the stock price depends on what
people expect that other people
expect, etc.
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• Dow Jones Industrial Average
Index:
• An index based on the stock prices of
30 actively traded large companies.
The oldest and most widely followed
index of stock market performance.
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• NASDAQ Composite Index:
• An index based on the stock prices of
over 5,000 companies traded on the
NASDAQ stock market. The NASDAQ
market takes is name from the National
Association of Securities Dealers
Automated Quotation System.
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• Standard and Poors 500 (S&P 500)
Index:
• An index based on the stock prices of
the largest 500 firms traded on the New
York Stock Exchange, the NASDAQ
stock market, and the American Stock
Exchange.
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• From a macroeconomic perspective,
the Dow Jones Industrial Average
and the NASDAQ index cover too
small a sample of firms.
• A better measure of the market value
of all firms in the economy is the
Standard and Poors 500 stock price
index, called the S&P 500.
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C H A P T E R 16: The Stock Market and the Economy
The S&P 500 Stock Price Index,
1948 I – 2002 III
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• Between 1995 and 2000, the S&P
500 index rose 226 percent, an
annual rate of 25 percent!
• This is by far the largest stock
market boom in U.S. history. This
boom added $14 trillion to household
wealth, about $2.5 trillion per year.
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C H A P T E R 16: The Stock Market and the Economy
The Stock Market Since 1948
• The stock market boom cannot be
explained by a large fall in interest
rates, higher profits, or a fall in the
perceived riskiness of stocks. This
led many people to the view that it
was simply a bubble.
• Millions of lives were affected by the
euphoria of the boom and the
“correction” that followed.
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C H A P T E R 16: The Stock Market and the Economy
Growth Rate of S&P 500 Earnings,
1948 I – 2002 III
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C H A P T E R 16: The Stock Market and the Economy
Ratio of Profits to GDP,
1948 I – 2002 III
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C H A P T E R 16: The Stock Market and the Economy
Stock Market Effects on the Economy
• An increase in stock prices causes
an increase in wealth, and
consequently an increase in
consumer spending.
• Investment is also affected by higher
stock prices. With a higher stock
price, a firm can raise more money
per share to finance investment
projects.
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C H A P T E R 16: The Stock Market and the Economy
The Crash of October 1987
• The value of stocks in the United
States fell by about a trillion dollars
between August 1987 and the end of
October 1987.
• If the multiplier is 1.4, the $1 trillion
decrease in wealth in 1987 implies a
$40 billion lower level of spending in
1988, or about 1.4 percent of GDP.
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C H A P T E R 16: The Stock Market and the Economy
The Crash of October 1987
• However, as the life-cycle theory of
consumption predicts, households
smooth their consumption over time,
which means that the decrease in
wealth would not have reduced
consumption in the current year by
the full amount of the decrease in
wealth, but by cutting consumption a
little each year.
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C H A P T E R 16: The Stock Market and the Economy
The Crash of October 1987
• The stock market crash of 1987 did
not result in a recession in 1988
because households and business
firms did not lower their expectations
drastically.
• Since the initial decrease in wealth
turned out to be temporary, the
negative wealth effect was not as
large as anticipated.
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C H A P T E R 16: The Stock Market and the Economy
The Boom of 1995-2000
• The boom in the economy between
1995 and 2000 was fueled by the
stock market boom.
• Estimates show that had there been
no stock market boom the economy
would not have looked historically
unusual in the last half of the 1990s.
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C H A P T E R 16: The Stock Market and the Economy
The Boom of 1995-2000
• The value of stocks increased by
about $2.5 trillion per year during the
boom.
• Assuming that a $1 increase in stock
prices leads to a $0.04 increase in
consumption and investment, and a
multiplier of 1.4, then:
0.04 x $2.5 trillion x 1.4 = $140 billion
increase in GDP, or 1.5% of GDP.
• The growth rate of GDP would have
been around 2.8% instead of 4.5%
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C H A P T E R 16: The Stock Market and the Economy
Personal Saving Rate,
1995 I – 2002 III
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• Had there been no
boom:
• The personal saving
rate would have been
higher.
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C H A P T E R 16: The Stock Market and the Economy
Investment Output Ratio,
1995 I – 2002 III
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• Had there been no
boom:
• Firms would have
invested less in plant
and equipment.
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C H A P T E R 16: The Stock Market and the Economy
Ratio of Federal Government Budget
Surplus to GDP, 1995 I – 2002 III
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• Had there been no
boom:
• The federal
government surplus
would not have been
as high, since taxable
income and profits
would have been less.
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C H A P T E R 16: The Stock Market and the Economy
The Boom of 1995-2000
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• Had there been no
boom:
• There would have
been no stock market
correction in 2001 and
2002, and the growth
rate of real GDP would
have been higher.
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C H A P T E R 16: The Stock Market and the Economy
The Unemployment Rate,
1995 I – 2002 III
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• Had there been no
boom:
• The unemployment
rate would have
remained at about 5.5
percent. It was 4%
during the boom.
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C H A P T E R 16: The Stock Market and the Economy
Inflation Rate, 1995 I – 2002 III
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• Had there been no
boom:
• Inflation would have
been lower due to less
demand pressure.
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C H A P T E R 16: The Stock Market and the Economy
3-Month Treasury Bill Rate,
1996 I – 2002 III
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• Had there been no
boom:
• The 3-month Treasury
bill rate and interest
rates as a whole would
have been lower.
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C H A P T E R 16: The Stock Market and the Economy
Fed Policy and the Stock Market
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• This figure shows that
the Fed is influenced
by the stock market.
• The Fed cares about
the stock market to the
extent that the market
affects the things that
it ultimately cares
about, namely output,
unemployment, and
inflation.
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C H A P T E R 16: The Stock Market and the Economy
Key Terms and Concepts
bond
capital gain
Dow Jones Industrial Average Index
NASDAQ Composite Index
realized capital gain
Standard and Poors 500 (S&P 500) Index
stock
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