ut stock market

Using All the Theory: Using All the Theory: The Stock Market and The Stock Market and

the Macroeconomythe Macroeconomy

© 2003 South-Western/Thomson Learning© 2003 South-Western/Thomson Learning

Basic BackgroundBasic Background

•Why Do People Hold Why Do People Hold Stock?Stock?

•Tracking the Stock MarketTracking the Stock Market

Basic BackgroundBasic Background

A share of stock is a private A share of stock is a private financial asset that is a financial asset that is a

share of share of ownership ownership in a in a corporation.corporation.

Why Do People Hold Why Do People Hold Stock?Stock?

Individuals hold some of their Individuals hold some of their wealth in stocks in order to wealth in stocks in order to receive the part of corporate receive the part of corporate profits that is distributed as profits that is distributed as

dividends.dividends.

A second - and usually more A second - and usually more important - reason that people important - reason that people hold stocks is that they hope to hold stocks is that they hope to

enjoy enjoy capital gains.capital gains.

Tracking the Stock Tracking the Stock MarketMarket

Stock and bond prices are Stock and bond prices are monitored on a continuous basis.monitored on a continuous basis.

In addition to monitoring In addition to monitoring individual stocks, the media keep individual stocks, the media keep

a close watch on many stock a close watch on many stock market indices or averages.market indices or averages.

Explaining Stock Explaining Stock PricesPrices

The stock market is a The stock market is a collection of individual, collection of individual, perfectly competitive perfectly competitive markets for particular markets for particular corporations’ shares.corporations’ shares.

Explaining Stock PricesExplaining Stock Prices

Stockholders are concerned about Stockholders are concerned about both the rate of return and the both the rate of return and the

risk associated with stocks. risk associated with stocks.

In practice, they try to allocate In practice, they try to allocate their total wealth among a their total wealth among a

collection of assets - including collection of assets - including stocks - that strikes the right stocks - that strikes the right

balance between risk and return.balance between risk and return.


Number of Shares

Priceper Share

E

S

$90

60

30

D

298 million

Explaining Stock Prices Explaining Stock Prices

The supply curve for a stock The supply curve for a stock tells us the quantity of shares tells us the quantity of shares in existence at any moment in in existence at any moment in

timetime. .

This is the number of shares This is the number of shares that people are that people are actually actually

holdingholding..


The desire to hold a stock is The desire to hold a stock is given by the downward-given by the downward-sloping demand curve.sloping demand curve.


Only at the Only at the equilibrium price - equilibrium price - where the supply and demand where the supply and demand curves intersect - are people curves intersect - are people

satisfied holding the number of satisfied holding the number of shares they are shares they are actually actually

holding.holding.


The changes we observe in a The changes we observe in a stock’s price - over a few stock’s price - over a few

minutes, a few days, or a few minutes, a few days, or a few years - are virtually always years - are virtually always

caused by shifts in the demand caused by shifts in the demand curve.curve.


Number of Shares

Priceper

Share

S

$75

60

(a) (b)

298 million

The demand curve shiftsrightward when newinformation causesexpectations of:• higher future profits• economic expansion• lower interest rates

Number of Shares

Priceper

Share

S

45

$60

298 million

The demand curve shiftsleftward when newinformation causesexpectations of:• lower future profits• recession• higher interest rates

D2

D1D1

D3


Any new information that Any new information that increasesincreases expectations of expectations of

firms’ future profits - firms’ future profits - announcements of new announcements of new

scientific discoveries, business scientific discoveries, business developments, or changes developments, or changes

in government policy - will in government policy - will shift the demand curves of the shift the demand curves of the

affected stocks affected stocks rightwardrightward..


New information that New information that decreasesdecreases expectations of expectations of

future profits will shift the future profits will shift the demand curves demand curves leftwardleftward..


Any news that suggests the Any news that suggests the economy will economy will enter an enter an expansionexpansion, or that an , or that an

expansion will continue, will expansion will continue, will shift the demand curves for shift the demand curves for

most stocks most stocks rightwardrightward. .


Any news that suggests an Any news that suggests an economic economic slowdown slowdown or a or a

coming coming recessionrecession shifts the shifts the demand curves for most stocks demand curves for most stocks

leftwardleftward..


A A riserise in the interest rate in in the interest rate in the economy will shift the the economy will shift the

demand curves for most stocks demand curves for most stocks to the to the leftleft. .

A A dropdrop in the interest rate will in the interest rate will shift the demand curves for shift the demand curves for

most stocks to the most stocks to the rightright..


News that causes people to News that causes people to anticipate a riseanticipate a rise in the interest in the interest

rate will shift the demand rate will shift the demand curves for stocks curves for stocks leftwardleftward. .

News that News that suggests a future suggests a future dropdrop in the interest rate will in the interest rate will shift the demand curves for shift the demand curves for

stocks stocks rightwardrightward..

The Stock Market The Stock Market and the Macroeconomyand the Macroeconomy

•How the Stock Market How the Stock Market Affects the EconomyAffects the Economy

•How the Economy Affects How the Economy Affects the Stock Marketthe Stock Market

The Stock Market The Stock Market and the Macroeconomyand the Macroeconomy

Stock Market Macroeconomy

How the Stock Market How the Stock Market Affects the EconomyAffects the Economy

•The Wealth EffectThe Wealth Effect

•The Wealth Effect and Equilibrium The Wealth Effect and Equilibrium GDPGDP

The Wealth EffectThe Wealth Effect

Autonomous consumption Autonomous consumption spending tends to move in spending tends to move in the same direction as stock the same direction as stock prices. prices.

• When stock prices rise, When stock prices rise, autonomous consumption autonomous consumption spending rises.spending rises.

• When stock prices fall, When stock prices fall, autonomous consumption autonomous consumption spending falls with it.spending falls with it.

The Wealth Effect and The Wealth Effect and Equilibrium GDPEquilibrium GDP

(a) (b)

Y1 Y2 Real GDP

AggregateExpenditure

AE higher stock prices

Real GDP

PriceLevel

Y1 Y3 Y2

AS

45º

AE lower stockprices

higher stock pricesAD

lower stock pricesAD

P1

P2


Stock prices

Autonomous consumption spending

Both real GDP and price level

Household wealth

Multiplier

effect


Changes in stock prices - Changes in stock prices - through the wealth effect - through the wealth effect - cause both equilibrium GDP cause both equilibrium GDP and the price level to move in and the price level to move in the same direction. the same direction.

• An increase in stock prices will An increase in stock prices will raise equilibrium GDP and the raise equilibrium GDP and the price level. price level.

• A decrease in stock prices will A decrease in stock prices will decrease both equilibrium GDP decrease both equilibrium GDP and the price level.and the price level.


Rapid Rapid increasesincreases in stock prices in stock prices can cause significant positive can cause significant positive

demand shocks to the economy, demand shocks to the economy, shocks that policy makers shocks that policy makers

cannot ignore. cannot ignore.

Rapid Rapid decreasesdecreases in stock prices in stock prices can cause significant negative can cause significant negative

demand shocks to the economy, demand shocks to the economy, which would be a major concern which would be a major concern

for policy makers.for policy makers.

How the Economy How the Economy Affects The Stock Affects The Stock

Market: Market: ExpansionExpansion

Real GDP

Expected future profits

Current profits

Demand curves for stocks shift rightward

Current stock prices

How the Economy How the Economy Affects The Stock Affects The Stock Market: Market: RecessionRecession

Real GDP


Current profits

Demand curves for stocks shift leftward

Current stock prices

How the Economy How the Economy Affects The Stock Affects The Stock

Market Market In the typical In the typical expansionexpansion, ,

higher profits and stockholder higher profits and stockholder optimism cause optimism cause stock prices to stock prices to

riserise. .

In the typical In the typical recessionrecession, lower , lower profits and stockholder profits and stockholder

pessimism cause pessimism cause stock prices stock prices to fallto fall..

What Happens What Happens When Things Change?When Things Change?•A Shock to the EconomyA Shock to the Economy

•A Shock to the Economy A Shock to the Economy and and the the Stock Market: The High-Tech Stock Market: The High-Tech

Boom of the 1990sBoom of the 1990s•A Shock to the Economy A Shock to the Economy and and the the Stock Market: The High-Tech Bust Stock Market: The High-Tech Bust

of 2000 and 2001of 2000 and 2001•The Fed and the Stock MarketThe Fed and the Stock Market

What Happens When What Happens When Things Change?Things Change?

Stock M arket

Shock to bothstock m arket andm acroeconom y

M acroeconom y

Shock tostock m arket

Shock tom acroeconom y

A Shock to the A Shock to the EconomyEconomy

Real GDP

Government purchases


Real GDP

Corporate profits



Stock prices

Real GDP

Autonomous consumption spending


When we include the effects of When we include the effects of the stock market, the the stock market, the expenditure multiplier is expenditure multiplier is larger. larger.

An increase in spending that An increase in spending that increases real GDP will increases real GDP will

• also cause stock prices to rise, also cause stock prices to rise, • causing still greater increases causing still greater increases

in real GDP.in real GDP.


A decrease in spending that A decrease in spending that causes real GDP to fall will causes real GDP to fall will

• also cause stock prices to also cause stock prices to fall, fall,

• causing still greater causing still greater decreases in real GDP.decreases in real GDP.

The High-Tech The High-Tech Boom of the 1990sBoom of the 1990s

• Mid-1999: Fed thought Mid-1999: Fed thought wealth effect would overheat wealth effect would overheat the economy if nothing donethe economy if nothing done

• From June 1999 through From June 1999 through May 2000:May 2000:–Fed raised target for the Fed Fed raised target for the Fed funds rate funds rate sixsix times times

The High-Tech Bust The High-Tech Bust of 2000 and 2001of 2000 and 2001

• Market began to decline in Market began to decline in early 2000early 2000

• Investment rush of the Investment rush of the 1990s ended 1990s ended –firms caught up to new firms caught up to new technologytechnology–investment spending investment spending decreaseddecreased–recession beganrecession began–stock prices fellstock prices fell


• Change in expectations Change in expectations about futureabout future–companies went bankruptcompanies went bankrupt–optimism about future optimism about future profits shifted to pessimismprofits shifted to pessimism–share prices fellshare prices fell


• Consumption spending Consumption spending remained strong due toremained strong due to–forces other than the drop forces other than the drop in share pricesin share prices–Fed interest rate Fed interest rate reductionsreductions

The Fed and the Stock The Fed and the Stock MarketMarket

• Technological changes of Technological changes of the 1990s: shock to both the the 1990s: shock to both the stock market stock market and and the the economy.economy.

• Fed concern: the market was Fed concern: the market was experiencing a speculative experiencing a speculative bubblebubble


Real GDP

PriceLevel

Y1 Y2

(a)

P1

P2

AD2

AD1

AS1

A

(b)

Real GDP

PriceLevel

P1

P2

Y1 Y2

AS1

Wealth effect of risingstock prices shifts ADrightward, raising realGDP and the price level

AS2

AD1

AD2A

P3

correcting mechanism

If output exceedspotential, the self-

will raise the pricelevel further

B

C

B


Unemployment Rate

InflationRate

4% 5%

2.5%

5.0%

1.5%

But if the naturalrate is above 4%the Phillips Curvewill shift upwardand the Fed mustchoose betweenhigher inflation …

… orrecession

Unemployment Rate

InflationRate

4%

2.5%

UN?

If the natural rateof unemploymentis 4%, the Fed cankeep the economyat point A in thelong run

PC21PCPC1

AD

B

C

A

UN?

(a) (b)

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