Using the Theory

Economics: Principles and Economics: Principles and Applications, 2eApplications, 2e

by Robert E. Hall & by Robert E. Hall & Marc LiebermanMarc Lieberman

© 2001 South-Western, a division of Thomson Learning© 2001 South-Western, a division of Thomson Learning

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

the Macroeconomythe Macroeconomy


Basic BackgroundBasic Background

•Why Do People Hold Stock?Why Do People Hold Stock?•Tracking the Stock MarketTracking the Stock Market



A share of stock is a private financial asset A share of stock is a private financial asset that is a share of that is a share of ownership ownership in a corporation.in a corporation.



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

distributed as distributed as dividends.dividends. A second--and usually A second--and usually more important--reason that people hold stocks is more important--reason that people hold stocks is

that they hope to enjoy that they hope to enjoy capital gains.capital gains.



In the United States, financial markets are so In the United States, financial markets are so important that stock and bond prices are monitored important that stock and bond prices are monitored

on a continuous basis. In addition to monitoring on a continuous basis. In addition to monitoring individual stocks, the media keep a close watch on individual stocks, the media keep a close watch on

many stock market indices or averages.many stock market indices or averages.


Explaining Stock PricesExplaining Stock Prices

•Key Step #1: Characterize the MarketKey Step #1: Characterize the Market•Key Step #2: Identify the Goals and ConstraintsKey Step #2: Identify the Goals and Constraints

•Key Step #3: Find the EquilibriumKey Step #3: Find the Equilibrium•Key Step #4: What Happens When Things Change?Key Step #4: What Happens When Things Change?


Explaining Stock Prices Explaining Stock Prices

We will view the stock market as a collection We will view the stock market as a collection of individual, perfectly competitive markets of individual, perfectly competitive markets

for particular corporations’ shares.for particular corporations’ shares.



Stockholders are concerned about both the rate of Stockholders are concerned about both the rate of return and the risk associated with stocks. In return and the risk associated with stocks. In practice, they try to allocate their total wealth practice, they try to allocate their total wealth

among a collection of assets--including stocks--that among a collection of assets--including stocks--that strikes the right balance between risk and return.strikes the right balance between risk and return.



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

in time. This is the number of shares that in time. This is the number of shares that people are people are actually actually holding.holding.



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



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

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



The changes we observe in a stock’s price--The changes we observe in a stock’s price--over a few minutes, a few days, or a few over a few minutes, a few days, or a few

years--are virtually always caused by shifts in years--are virtually always caused by shifts in the demand curve.the demand curve.



Any new information that Any new information that increases increases expectations of firms’ expectations of firms’ future profits--including announcements of new scientific future profits--including announcements of new scientific

discoveries, business developments, or changes in discoveries, business developments, or changes in government policy--will shift the demand curves of the government policy--will shift the demand curves of the

affected stocks rightward. New information that affected stocks rightward. New information that decreasesdecreases expectations of future profits will shift the demand curves expectations of future profits will shift the demand curves

leftward.leftward.© 2001 South-Western, a division of Thomson Learning© 2001 South-Western, a division of Thomson Learning


Any news that suggests the economy will enter an Any news that suggests the economy will enter an expansion, or that an expansion will continue, will shift the expansion, or that an expansion will continue, will shift the demand curves for most stocks rightward. Any news that demand curves for most stocks rightward. Any news that suggests an economic slowdown or a coming recession suggests an economic slowdown or a coming recession

shifts the demand curves for most stocks leftward.shifts the demand curves for most stocks leftward.



A rise in the interest rate in the economy will shift A rise in the interest rate in the economy will shift the demand curves for most stocks to the left. the demand curves for most stocks to the left.

Similarly, a drop in the interest rate will shift the Similarly, a drop in the interest rate will shift the demand curves for most stocks to the right.demand curves for most stocks to the right.



News that causes people to News that causes people to anticipate anticipate a rise in the a rise in the interest rate will shift the demand curves for stocks interest rate will shift the demand curves for stocks leftward. Similarly, news that suggests a future drop leftward. Similarly, news that suggests a future drop in the interest rate will shift the demand curves for in the interest rate will shift the demand curves for

stocks rightward.stocks rightward.© 2001 South-Western, a division of Thomson Learning© 2001 South-Western, a division of Thomson Learning

The Stock Market The Stock Market and the Macroeconomyand the Macroeconomy

•How the Stock Market Affects the EconomyHow the Stock Market Affects the Economy•How the Economy Affects the Stock MarketHow the Economy Affects the Stock Market


The Stock Market The Stock Market and the Macroeconomy and the Macroeconomy

The wealth effect tells us that autonomous consumption The wealth effect tells us that autonomous consumption spending tends to move in the same direction as stock spending tends to move in the same direction as stock

prices. When stock prices rise, autonomous consumption prices. When stock prices rise, autonomous consumption spending rises; when stock prices fall, autonomous spending rises; when stock prices fall, autonomous

consumption spending falls with it.consumption spending falls with it.



Changes in stock prices--through the wealth effect--cause Changes in stock prices--through the wealth effect--cause both equilibrium GDP and the price level to move in the both equilibrium GDP and the price level to move in the same direction. That is, an increase in stock prices will same direction. That is, an increase in stock prices will

raise equilibrium GDP and the price level, while a decrease raise equilibrium GDP and the price level, while a decrease in stock prices will decrease both equilibrium GDP and the in stock prices will decrease both equilibrium GDP and the

price level.price level.



Rapid increases in stock prices can cause significant Rapid increases in stock prices can cause significant positive demand shocks to the economy, shocks that policy positive demand shocks to the economy, shocks that policy makers cannot ignore. Similarly, rapid decreases in stock makers cannot ignore. Similarly, rapid decreases in stock

prices can cause significant negative demand shocks to the prices can cause significant negative demand shocks to the economy, which would be a major concern for policy economy, which would be a major concern for policy

makers.makers.



In the typical expansion, higher profits and In the typical expansion, higher profits and stockholder optimism cause stock prices to rise. In stockholder optimism cause stock prices to rise. In the typical recession, lower profits and stockholder the typical recession, lower profits and stockholder

pessimism cause stock prices to fall.pessimism cause stock prices to 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 Stock Market: The 1990sthe Stock Market: The 1990s•The Fed’s Dilemma in the Late 1990s and Early 2000The Fed’s Dilemma in the Late 1990s and Early 2000


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

When we include the effects of the stock market, When we include the effects of the stock market, the expenditure multiplier is larger. An increase in the expenditure multiplier is larger. An increase in spending that increases real GDP will also cause spending that increases real GDP will also cause

stock prices to rise, causing still greater increases in stock prices to rise, causing still greater increases in real GDP.real GDP.



A decrease in spending that causes real GDP A decrease in spending that causes real GDP to fall will also cause stock prices to fall, to fall will also cause stock prices to fall,

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



The technological changes of the 1990s were The technological changes of the 1990s were an example of a shock to both the stock an example of a shock to both the stock

market market and and the economy.the economy.



Around 1995 and 1996, some officials at the U.S. Around 1995 and 1996, some officials at the U.S. Federal Reserve began to worry that share prices Federal Reserve began to worry that share prices were rising out of proportion to the future profits were rising out of proportion to the future profits

they would be able to deliver to their owners.they would be able to deliver to their owners.



The Fed was worried that the market was The Fed was worried that the market was experiencing a speculative experiencing a speculative bubble--bubble--a frenzy of a frenzy of

buying that encouraged people to buy stocks and buying that encouraged people to buy stocks and drive up their price just because their prices were drive up their price just because their prices were

rising.rising.



Beginning in mid-1999, Fed officials believed that Beginning in mid-1999, Fed officials believed that the wealth effect would overheat the economy if the wealth effect would overheat the economy if

nothing were done. From June 1999 through May nothing were done. From June 1999 through May 2000, the Fed raised its target for the federal funds 2000, the Fed raised its target for the federal funds

rate six times.rate six times.


Using the Theory

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