Stock Market And The Economy

: 82 R E T P A H C

•The STock
MarkeT
and The
econoMy

© 2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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The Stock Market
and the Economy
• The stock market boom of the last
half of the 1990s had a large impact
on the economy.
• How much of the economic growth was

due to the stock market boom?
• Did the economy in fact enter a new
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age?



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Stocks and Bonds

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• To make a large purchase, a firm
can borrow the funds from a bank,
but it can also issue a bond.
• A bond is a document that formally
promises to pay back a loan under
specified terms and a given period of
time.



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Bonds
• Bonds have several properties:
• Face value, or the amount the buyer

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agrees to lend to the bond issuer



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Bonds
• Maturity date, or the date when the

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funds are paid back to the lender
(although the lender may sell the bond
before maturity).



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Bonds
• A fixed payment, known as a coupon,

calculated using the prevailing interest
rate at the time of issue.
• The bondholder receives a set amount,

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known in advance, no matter what happens
to interest rates, stock prices, and so on.



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Bonds
• Instead of the coupon responding to a

change in the interest rate, it is the price
of the bond that changes.
• The bond is worth less when interest

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rates rise.



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Bonds
15-yr. Bond

Bank Account

Face Value: $10,000
Coupon rate: 10%

requires only: $5,000
with interest rate of 20%

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Yearly payment of
$1,000


To obtain same yearly
payment of $1,000


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Stocks

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• 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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Stocks

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• 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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Stocks
• A capital gain is an increase in the
value of an asset.

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• 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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Stocks

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• 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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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

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paid
• The amount of risk involved



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• 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.
10%

Amount today
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Interest rate

$100 $104.76

Pays one year
from now

$110



5%

$110

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• 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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• 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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• 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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The Stock Market Since 1948
• Dow Jones Industrial Average
Index:
• An index based on the stock prices of

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30 actively traded large companies.
The oldest and most widely followed
index of stock market performance.



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• NASDAQ Composite Index:

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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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• Standard and Poors 500 (S&P 500)
Index:

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the largest 500 firms traded on the New
York Stock Exchange, the NASDAQ
stock market, and the American Stock
Exchange.



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• 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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The S&P 500 Stock Price Index,
1948 I – 2002 III



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• 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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• 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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Growth Rate of S&P 500 Earnings,
1948 I – 2002 III



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Ratio of Profits to GDP,
1948 I – 2002 III



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Stock Market Effects on the Economy

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• 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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The Crash of October 1987

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• 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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• 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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• 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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The Boom of 1995-2000

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• 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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• The value of stocks increased by
about $2.5 trillion per year during the
boom.
• Assuming that a $1 increase in stock

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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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Personal Saving Rate,
1995 I – 2002 III
• Had there been no
boom:
• The personal saving

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rate would have been
higher.



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Investment Output Ratio,
1995 I – 2002 III
boom:
• Firms would have

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invested less in plant
and equipment.



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Ratio of Federal Government Budget
Surplus to GDP, 1995 I – 2002 III
boom:

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• The federal


government surplus
would not have been
as high, since taxable
income and profits
would have been less.


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boom:

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• 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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The Unemployment Rate,
1995 I – 2002 III
boom:
• The unemployment

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rate would have
remained at about 5.5
percent. It was 4%
during the boom.



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Inflation Rate, 1995 I – 2002 III
boom:
• Inflation would have

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been lower due to less
demand pressure.



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3-Month Treasury Bill Rate,
1996 I – 2002 III
boom:
• The 3-month Treasury

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bill rate and interest
rates as a whole would
have been lower.



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Fed Policy and the Stock Market
• This figure shows that
the Fed is influenced
by the stock market.

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• 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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Key Terms and Concepts
bond
capital gain
Dow Jones Industrial Average Index
NASDAQ Composite Index
realized capital gain
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Standard and Poors 500 (S&P 500) Index
stock



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Stock Market And The Economy

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