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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