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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