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Prepared by: Fernando QuijanoPrepared by: Fernando Quijanoand Yvonn Quijanoand Yvonn Quijano

© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Stock Marketand the Economy

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2 of 41© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair

The Stock Marketand 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 age?

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Stocks and Bonds

• 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 agrees to lend to the bond issuer

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Bonds


• 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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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, 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 rates rise.

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Bonds

15-yr. Bond

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

Yearly payment of $1,000

Bank Account

requires only: $5,000

with interest rate of 20%

To obtain same yearly payment of $1,000

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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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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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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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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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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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• 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% 5%

Amount today $100 $104.76

Pays one year from now $110 $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 30 actively traded large companies. The oldest and most widely followed index of stock market performance.

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• 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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• 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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• 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

• 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

• 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

• 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 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 rate would have been higher.

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Investment Output Ratio,1995 I – 2002 III


• Firms would have invested less in plant and equipment.

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


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

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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


• The unemployment 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


• Inflation would have been lower due to less demand pressure.

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3-Month Treasury Bill Rate,1996 I – 2002 III


• The 3-month Treasury 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.

• 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

Standard and Poors 500 (S&P 500) Index

stock