Stock Market and Macroeconomy - PowerPoint PPT Presentation


Title: Stock Market and Macroeconomy


1
Stock Market and Macroeconomy
  • Share of stock is a private financial asset,
    like a corporate bond
  • Both are issued by corporations to raise funds,
    both offer future payments to their owners
  • but what is the main difference between these
    two?
  • When a firm issues new shares of stock- called
    public offerings sale of which generates funds
    for the firm- newly issued shares can be sold to
    someone else
  • Virtually all the shares traded in the stock
    market are previously issued- trading doesnt
    involve the firm that issued the stock

2
Contd
  • But why the firm still concerned about the price
    of its previously issued share?
  • - first, the firms owners-its
    stockholders-want high share prices because that
    is the price they can sell at
  • -second, previously issued shares are
    perfect substitute of new public offerings
  • ------------therefore, the firm cannot
    expect to receive higher price for its new shares
    than the going price on its old shared
  • ---what is the result then??

3
Contd..
  • In 1983, only 19 percents of Americans owned
    share of stocks either directly or through mutual
    funds(?) in 2003, almost 50 American owned
    stock
  • You own a share of stock implies you own part of
    the corporation-own a fraction of the companys
    total stock
  • you are entitled to a particular percent of the
    firms after tax profit
  • However, firms do not pay all their after-tax
    profit to share holders- some is kept as retained
    earnings for later use of the firm
  • The part of profit distributed to share holders
    is called dividends
  • Aside from dividends, usually more important
    reason to holding stocks is to enjoy capital
    gains return someone gets when they sell a
    stock at a higher price than they paid for it

4
Tracking the stock market
  • Financial market is so important that stocks and
    bonds are monitored on a continuous basis
  • You can find out the value of a stock instantly
    just by checking with a broker or logging onto a
    website
  • Daily news paper or specialized financial
    publication such as Wall Street Journal or
    Financial Times report daily information
  • In addition to that, there are many stock market
    indices

5
Tracking..
  • Oldest and most popular average
  • Dow Jones Industrial Average (DJIA)-tracks prices
    of 30 of the largest companies
  • Another popular average
  • Broader Standard Poors 500 (SP 500)
  • NASDAQ index tracks share prices of about 5,000
    mostly newer companies whose shares are traded on
    NASDAQ stock exchange
  • Often, stock market averages will rise and fall
    at the same time, sometimes by the same
    percentage
  • In spite of falling stock prices in 2000 and
    2001, the last decade was good for stocks

6
Explaining Stock PricesStep 1 Characterize The
Market
  • Price of a share of stocklike any other is
    determined in a market
  • Well characterize the market for a companys
    shares as perfectly competitive
  • View stock market as a collection of individual,
    perfectly competitive markets for particular
    corporations shares
  • Many buyers and sellers
  • Virtually free entry

7
Step 2 Find The Equilibrium
  • Like all prices in competitive markets, stock
    prices are determined by supply and demand
  • However, in stock markets, supply and demand
    curves require careful interpretations
  • Figure 1 presents a supply and demand diagram for
    shares of Fedex Corporation
  • On any given day, number of Fedex shares in
    existence is just the number that the firm has
    issued previously
  • Just because 302 million shares of Fedex stock
    exist, that does not mean that this is the number
    of shares that people will want to hold
  • People have different expectations about firms
    future profits
  • At any price other than 90 per share, number of
    shares people are holding (on the supply curve)
    will differ from number they want to hold (on the
    demand curve)
  • Only at equilibrium price of 90 people
    satisfied holding number of shares they are
    actually holding
  • Stocks achieve their equilibrium prices almost
    instantly

8
Figure 1 The Market For Shares of Fedex
Corporation
S
Price per Share
120
E
90
60
D
Number of Shares
302 million
9
Step 3 What Happens When Things Change?
  • Supply curve for a corporations shares shifts
    rightward whenever there is a public offering
  • The changes we observe in a stocks priceover a
    few minutes, a few days, or a few yearsare
    virtually always caused by shifts in demand curve
  • what causes these sudden changes in demand for a
    share of stock?
  • In almost all cases, it is one or more of the
    following three factors
  • Changes in expected future profits of firm
  • Any new information that increases expectations
    of firms future profits will shift demand curves
    of affected stocks rightward
  • Including announcements of new scientific
    discoveries, business developments, or changes in
    government policy
  • Macroeconomic Fluctuations
  • Any news that suggests economy will enter an
    expansion, or that an expansion will continue,
    will shift demand curves for most stocks
    rightward
  • Changes in the interest rate
  • A rise (drop) in the interest rate in the economy
    will shift the demand curves for most stocks to
    the left (right)

10
Step 3 What Happens When Things Change?
  • Even expectations of a future interest rate
    change can shift demand curves for stocks
  • Such an event occurred on February 27, 2002, when
    Fed Chair Greenspan announced that it appeared
    economy was recovering from its recession
  • News that causes people to anticipate a rise in
    interest rate will shift demand curves for stocks
    leftward
  • Similarly, news that suggests a future drop in
    the interest rate will shift demand curves for
    stocks rightward

11
Figure 2a Shifts in the Demand for Shares Curve
(a)
S
Price per Share
75
60
D2
D1
Number of Shares
298 million
12
Figure 2b Shifts in the Demand for Shares Curve
(b)
S
Price per Share
60
45
D1
D3
Number of Shares
298 million
13
Figure 3 The Two-Way Relationship Between The
Stock Market and the Economy
14
How the Stock Market Affects the Economy
  • On October 19, 1987, there was a dramatic drop in
    the stock market
  • One that made decline on September 17, 2001 seem
    small by comparison
  • Dow Jones Industrial Average fell by 508 pointsa
    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 dont own any stocks
  • It was a curious exchange (perhaps Reagan was
    joking)
  • Whatever Reagans intent, statement was startling
  • Because, in fact, stock market does matter to all
    Americans

15
The Wealth Effect
  • To understand how market affects economy, lets
    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)

16
The Wealth Effect and Equilibrium GDP
  • Autonomous consumption is a component of total
    spending
  • Can summarize logic of the wealth effect

Changes in stock pricesthrough the wealth
effectcause 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
17
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
    DJIAwhich generally means a rise in stock prices
    in generalcauses household wealth to rise by
    about 100 billion
  • This rise in household wealth will increase
    autonomous consumption spending by between 3
    billion and 5 billionwell 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

18
Figure 4 The Effect of Higher Stock Prices on
the Economy
(a)
(b)
AS
Price Level
AEhigher stock prices
AElower stock prices
Aggregate Expenditure
P2
P1
ADhigher stock prices
ADlower stock prices
45
Real GDP
Real GDP
Y1
Y3
Y2
Y1
Y2
19
How the Economy Affects the Stock Market
  • Lets 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
  • Lets 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)

20
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

21
Figure 5 Three Types of Shocks
22
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

23
A Shock To the Economy and the Stock Market The
High-Tech Boom of the 1990s
  • 1990sespecially second halfsaw dramatic rise in
    stock prices
  • Growth in real GDP averaged 4.2 annually from
    1995-2000
  • In part, economic expansion and rise in stock
    prices were reinforcing
  • Each contributed to the other
  • Internet had a direct impact on stock market
    through its effect on expected future profits of
    U.S. firms
  • At the same time, technological revolution was
    having a huge impact on overall economy

24
A Shock To the Economy and the Stock Market The
High-Tech Boom of the 1990s
  • Faced with these demand shocks, Federal Reserve
    would ordinarily have raised its interest rate
    target to prevent real GDP from exceeding
    potential output
  • Technological changes of 1990s were an example of
    a shock to both stock market and economy
  • Result was a market and an economy that were
    feeding on each other, sending both to new
    performance heights
  • Was this a good thing?
  • Yes, and no
  • In spite of all this good news, there were dark
    clouds on horizon

25
A Shock to the Economy and the Stock Market The
High-Tech Bust of 2000 and 2001
  • The marketespecially high-tech NASDAQ
    stocksbegan to decline in early 2000
  • Both economy and market were being affected by
    several events discussed in earlier chapters of
    this book
  • During 1990s, there had been an investment boom
  • Businesses rushed to incorporate the internet
    into factories, offices, and their business
    practices in general
  • Fed may have played a role as well
  • Decline in investmentand the recession it
    causedcan be regarded as a shock to economy
  • In addition, there was a direct shock to market
  • A change in expectations about the future
  • Unfortunately, in late 2000 and early 2001,
    reality set in

26
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

27
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 effectthis time in a negative
    directionfrom 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 didnt work

28
The Fed and the Stock Market
  • Not only were Greenspans efforts to talk the
    market down unsuccessful, they were also widely
    criticized
  • Greenspan seemed to change his tune as 1990s
    continued
  • By 1998, he had stopped referring to
    exuberancerational or irrational
  • As 1990s came to a close, and the stock market
    continued to soar, Fed faced a new problem
  • Wealth effect
  • Figure 6 shows one way we can view Feds problem
  • With aggregate demand and supply curves
  • Figure 6 is useful, but it has a serious
    limitation
  • Doesnt take account of the rise in potential
    output
  • But the Phillips curve can illustrate Feds goal
    more easily
  • To keep inflation low and stable without needing
    corrective recessions, Fed strives to maintain
    unemployment at its natural rate

29
Figure 6 The Feds Problem In 2000 An AS-AD
View
(a)
(b)
AS2
Price Level
Price Level
AS
AS1
C
P3
B
P2
B
P2
A
AD2
AD2
A
P1
P1
AD1
AD1
Real GDP
Real GDP
Y1
Y2
Y1
Y2
30
Figure 7 The Feds Problem in 2000 A Phillips
Curve View
(a)
(b)
Inflation Rate
Inflation Rate
C
5.0
A
D
A
2.5
2.5
B
1.5
PC1
PC1
PC2
Unemployment Rate
Unemployment Rate
4
4
5
UN?
UN?
31
The Fed and the Stock Market
  • Might think Fed can estimate natural rate by a
    process of trial and error
  • Bring unemployment rate to a certain level (such
    as 4) and see what happens to inflation
  • Unfortunately, things are not so simple
  • Fed looks ahead and determines whether current
    economic conditions are likely to raise inflation
    rate in the future
  • That is just what Fed did beginning in mid-1999
  • By raising interest rates to rein in the economy,
    Fed also brought down stock prices
  • By slowing economic growth and growth in profits
  • Through direct effect of higher interest rates on
    stocks
  • By 2001, high-tech bust, recession of 2001, and
    attacks of September 11 brought criticism to an
    end
  • As the economy began a slow expansion, in 2002
    and early 2003, Fed kept the interest rate low
  • Unresolved question will surface again
  • Who should be setting the general level of share
    pricesmillions of stockholders who buy and sell
    shares, or Federal Reserve?
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Title: Stock Market and Macroeconomy


1
Stock Market and Macroeconomy
  • Share of stock is a private financial asset,
    like a corporate bond
  • Both are issued by corporations to raise funds,
    both offer future payments to their owners
  • but what is the main difference between these
    two?
  • When a firm issues new shares of stock- called
    public offerings sale of which generates funds
    for the firm- newly issued shares can be sold to
    someone else
  • Virtually all the shares traded in the stock
    market are previously issued- trading doesnt
    involve the firm that issued the stock

2
Contd
  • But why the firm still concerned about the price
    of its previously issued share?
  • - first, the firms owners-its
    stockholders-want high share prices because that
    is the price they can sell at
  • -second, previously issued shares are
    perfect substitute of new public offerings
  • ------------therefore, the firm cannot
    expect to receive higher price for its new shares
    than the going price on its old shared
  • ---what is the result then??

3
Contd..
  • In 1983, only 19 percents of Americans owned
    share of stocks either directly or through mutual
    funds(?) in 2003, almost 50 American owned
    stock
  • You own a share of stock implies you own part of
    the corporation-own a fraction of the companys
    total stock
  • you are entitled to a particular percent of the
    firms after tax profit
  • However, firms do not pay all their after-tax
    profit to share holders- some is kept as retained
    earnings for later use of the firm
  • The part of profit distributed to share holders
    is called dividends
  • Aside from dividends, usually more important
    reason to holding stocks is to enjoy capital
    gains return someone gets when they sell a
    stock at a higher price than they paid for it

4
Tracking the stock market
  • Financial market is so important that stocks and
    bonds are monitored on a continuous basis
  • You can find out the value of a stock instantly
    just by checking with a broker or logging onto a
    website
  • Daily news paper or specialized financial
    publication such as Wall Street Journal or
    Financial Times report daily information
  • In addition to that, there are many stock market
    indices

5
Tracking..
  • Oldest and most popular average
  • Dow Jones Industrial Average (DJIA)-tracks prices
    of 30 of the largest companies
  • Another popular average
  • Broader Standard Poors 500 (SP 500)
  • NASDAQ index tracks share prices of about 5,000
    mostly newer companies whose shares are traded on
    NASDAQ stock exchange
  • Often, stock market averages will rise and fall
    at the same time, sometimes by the same
    percentage
  • In spite of falling stock prices in 2000 and
    2001, the last decade was good for stocks

6
Explaining Stock PricesStep 1 Characterize The
Market
  • Price of a share of stocklike any other is
    determined in a market
  • Well characterize the market for a companys
    shares as perfectly competitive
  • View stock market as a collection of individual,
    perfectly competitive markets for particular
    corporations shares
  • Many buyers and sellers
  • Virtually free entry

7
Step 2 Find The Equilibrium
  • Like all prices in competitive markets, stock
    prices are determined by supply and demand
  • However, in stock markets, supply and demand
    curves require careful interpretations
  • Figure 1 presents a supply and demand diagram for
    shares of Fedex Corporation
  • On any given day, number of Fedex shares in
    existence is just the number that the firm has
    issued previously
  • Just because 302 million shares of Fedex stock
    exist, that does not mean that this is the number
    of shares that people will want to hold
  • People have different expectations about firms
    future profits
  • At any price other than 90 per share, number of
    shares people are holding (on the supply curve)
    will differ from number they want to hold (on the
    demand curve)
  • Only at equilibrium price of 90 people
    satisfied holding number of shares they are
    actually holding
  • Stocks achieve their equilibrium prices almost
    instantly

8
Figure 1 The Market For Shares of Fedex
Corporation
S
Price per Share
120
E
90
60
D
Number of Shares
302 million
9
Step 3 What Happens When Things Change?
  • Supply curve for a corporations shares shifts
    rightward whenever there is a public offering
  • The changes we observe in a stocks priceover a
    few minutes, a few days, or a few yearsare
    virtually always caused by shifts in demand curve
  • what causes these sudden changes in demand for a
    share of stock?
  • In almost all cases, it is one or more of the
    following three factors
  • Changes in expected future profits of firm
  • Any new information that increases expectations
    of firms future profits will shift demand curves
    of affected stocks rightward
  • Including announcements of new scientific
    discoveries, business developments, or changes in
    government policy
  • Macroeconomic Fluctuations
  • Any news that suggests economy will enter an
    expansion, or that an expansion will continue,
    will shift demand curves for most stocks
    rightward
  • Changes in the interest rate
  • A rise (drop) in the interest rate in the economy
    will shift the demand curves for most stocks to
    the left (right)

10
Step 3 What Happens When Things Change?
  • Even expectations of a future interest rate
    change can shift demand curves for stocks
  • Such an event occurred on February 27, 2002, when
    Fed Chair Greenspan announced that it appeared
    economy was recovering from its recession
  • News that causes people to anticipate a rise in
    interest rate will shift demand curves for stocks
    leftward
  • Similarly, news that suggests a future drop in
    the interest rate will shift demand curves for
    stocks rightward

11
Figure 2a Shifts in the Demand for Shares Curve
(a)
S
Price per Share
75
60
D2
D1
Number of Shares
298 million
12
Figure 2b Shifts in the Demand for Shares Curve
(b)
S
Price per Share
60
45
D1
D3
Number of Shares
298 million
13
Figure 3 The Two-Way Relationship Between The
Stock Market and the Economy
14
How the Stock Market Affects the Economy
  • On October 19, 1987, there was a dramatic drop in
    the stock market
  • One that made decline on September 17, 2001 seem
    small by comparison
  • Dow Jones Industrial Average fell by 508 pointsa
    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 dont own any stocks
  • It was a curious exchange (perhaps Reagan was
    joking)
  • Whatever Reagans intent, statement was startling
  • Because, in fact, stock market does matter to all
    Americans

15
The Wealth Effect
  • To understand how market affects economy, lets
    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)

16
The Wealth Effect and Equilibrium GDP
  • Autonomous consumption is a component of total
    spending
  • Can summarize logic of the wealth effect

Changes in stock pricesthrough the wealth
effectcause 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
17
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
    DJIAwhich generally means a rise in stock prices
    in generalcauses household wealth to rise by
    about 100 billion
  • This rise in household wealth will increase
    autonomous consumption spending by between 3
    billion and 5 billionwell 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

18
Figure 4 The Effect of Higher Stock Prices on
the Economy
(a)
(b)
AS
Price Level
AEhigher stock prices
AElower stock prices
Aggregate Expenditure
P2
P1
ADhigher stock prices
ADlower stock prices
45
Real GDP
Real GDP
Y1
Y3
Y2
Y1
Y2
19
How the Economy Affects the Stock Market
  • Lets 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
  • Lets 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)

20
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

21
Figure 5 Three Types of Shocks
22
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

23
A Shock To the Economy and the Stock Market The
High-Tech Boom of the 1990s
  • 1990sespecially second halfsaw dramatic rise in
    stock prices
  • Growth in real GDP averaged 4.2 annually from
    1995-2000
  • In part, economic expansion and rise in stock
    prices were reinforcing
  • Each contributed to the other
  • Internet had a direct impact on stock market
    through its effect on expected future profits of
    U.S. firms
  • At the same time, technological revolution was
    having a huge impact on overall economy

24
A Shock To the Economy and the Stock Market The
High-Tech Boom of the 1990s
  • Faced with these demand shocks, Federal Reserve
    would ordinarily have raised its interest rate
    target to prevent real GDP from exceeding
    potential output
  • Technological changes of 1990s were an example of
    a shock to both stock market and economy
  • Result was a market and an economy that were
    feeding on each other, sending both to new
    performance heights
  • Was this a good thing?
  • Yes, and no
  • In spite of all this good news, there were dark
    clouds on horizon

25
A Shock to the Economy and the Stock Market The
High-Tech Bust of 2000 and 2001
  • The marketespecially high-tech NASDAQ
    stocksbegan to decline in early 2000
  • Both economy and market were being affected by
    several events discussed in earlier chapters of
    this book
  • During 1990s, there had been an investment boom
  • Businesses rushed to incorporate the internet
    into factories, offices, and their business
    practices in general
  • Fed may have played a role as well
  • Decline in investmentand the recession it
    causedcan be regarded as a shock to economy
  • In addition, there was a direct shock to market
  • A change in expectations about the future
  • Unfortunately, in late 2000 and early 2001,
    reality set in

26
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

27
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 effectthis time in a negative
    directionfrom 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 didnt work

28
The Fed and the Stock Market
  • Not only were Greenspans efforts to talk the
    market down unsuccessful, they were also widely
    criticized
  • Greenspan seemed to change his tune as 1990s
    continued
  • By 1998, he had stopped referring to
    exuberancerational or irrational
  • As 1990s came to a close, and the stock market
    continued to soar, Fed faced a new problem
  • Wealth effect
  • Figure 6 shows one way we can view Feds problem
  • With aggregate demand and supply curves
  • Figure 6 is useful, but it has a serious
    limitation
  • Doesnt take account of the rise in potential
    output
  • But the Phillips curve can illustrate Feds goal
    more easily
  • To keep inflation low and stable without needing
    corrective recessions, Fed strives to maintain
    unemployment at its natural rate

29
Figure 6 The Feds Problem In 2000 An AS-AD
View
(a)
(b)
AS2
Price Level
Price Level
AS
AS1
C
P3
B
P2
B
P2
A
AD2
AD2
A
P1
P1
AD1
AD1
Real GDP
Real GDP
Y1
Y2
Y1
Y2
30
Figure 7 The Feds Problem in 2000 A Phillips
Curve View
(a)
(b)
Inflation Rate
Inflation Rate
C
5.0
A
D
A
2.5
2.5
B
1.5
PC1
PC1
PC2
Unemployment Rate
Unemployment Rate
4
4
5
UN?
UN?
31
The Fed and the Stock Market
  • Might think Fed can estimate natural rate by a
    process of trial and error
  • Bring unemployment rate to a certain level (such
    as 4) and see what happens to inflation
  • Unfortunately, things are not so simple
  • Fed looks ahead and determines whether current
    economic conditions are likely to raise inflation
    rate in the future
  • That is just what Fed did beginning in mid-1999
  • By raising interest rates to rein in the economy,
    Fed also brought down stock prices
  • By slowing economic growth and growth in profits
  • Through direct effect of higher interest rates on
    stocks
  • By 2001, high-tech bust, recession of 2001, and
    attacks of September 11 brought criticism to an
    end
  • As the economy began a slow expansion, in 2002
    and early 2003, Fed kept the interest rate low
  • Unresolved question will surface again
  • Who should be setting the general level of share
    pricesmillions of stockholders who buy and sell
    shares, or Federal Reserve?
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