The Stock Market and The Economy: Prepared By: Fernando Quijano and Yvonn Quijano

CHAPTER 16
The Stock Market

and the Economy
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
The Stock Market
and the Economy
C H A P T E R 16: The Stock Market and the Economy
• As recently as a decade ago

macroeconomics could ignore the
stock market because its impact on
the economy was small
• The stock market boom of the last

half of the 1990s had a large impact
on the economy.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 41
Business Investment and Finance
• To make a large purchase, a firm can borrow the funds from

a bank, but it can also issue a bond.
• 2. Investment projects are usually very large, often

requiring external financing.
• a. Internal financing means payment out of retained

earnings.
• b. External financing
• 3. Types of external financing
• a. Bank loans b. Issuing bonds c. Issuing stock
Stocks and Bonds
• A bond is a document that promises to pay back

a loan under specified terms and a given period
of time.
• Bonds have several properties:

• Face value, or the amount the buyer agrees to lend to
the bond issuer.
• Maturity date, or the date when the funds are paid back
to the lender (although the lender may sell the bond
before maturity).
Bonds
• A fixed payment, many bonds make

regular payments once or twice a
year. These payments are called
coupon payments. The coupon is a
fixed dollar amount specified in the
bond covenant.
Bonds
15-yr. Bond Bank Account

Face Value: $10,000 requires only: $5,000
Coupon rate: 10%
with interest rate of 20%
Yearly payment of To obtain same yearly

$1,000 payment of $1,000
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.
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.
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.
Stocks
• Most stocks bought and sold on the

stock market daily are not newly
issued but issued long ago, when the
firm “goes public.”
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
• 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
• The amount by which future

dividends are discounted is greater
when the possibility of obtaining
dividends from a firm is more
uncertain.
• 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.
• 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.
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.
• NASDAQ Composite Index:

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.
• Standard and Poors 500 (S&P 500)

Index:
the largest 500 firms traded on the New
York Stock Exchange, the NASDAQ
stock market, and the American Stock
Exchange.
• 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.
The S&P 500 Stock Price Index,
1948 I – 2002 III
• 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.
• 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.
Growth Rate of S&P 500 Earnings,
1948 I – 2002 III
Ratio of Profits to GDP,
1948 I – 2002 III
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.
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.
• 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.
• 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.
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.
• 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%
Personal Saving Rate,
1995 I – 2002 III
• Had there been no

boom:
• The personal saving
rate would have been
higher.
Investment Output Ratio,
1995 I – 2002 III

boom:
• Firms would have
invested less in plant
and equipment.
Ratio of Federal Government Budget
Surplus to GDP, 1995 I – 2002 III

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

boom:
• There would have
been no stock market
correction in 2001 and
2002, and the growth
rate of real GDP would
have been higher.
The Unemployment Rate,
1995 I – 2002 III

boom:
• The unemployment
rate would have
remained at about 5.5
percent. It was 4%
during the boom.
Inflation Rate, 1995 I – 2002 III

boom:
• Inflation would have
been lower due to less
demand pressure.
3-Month Treasury Bill Rate,
1996 I – 2002 III

boom:
• The 3-month Treasury
bill rate and interest
rates as a whole would
have been lower.
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.
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

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CHAPTER 16

The Stock Market

Prepared by: Fernando Quijano

• As recently as a decade ago

• The stock market boom of the last

• To make a large purchase, a firm can borrow the funds from

• 2. Investment projects are usually very large, often

• a. Internal financing means payment out of retained

• 3. Types of external financing

• a. Bank loans b. Issuing bonds c. Issuing stock

• A bond is a document that promises to pay back

• Bonds have several properties:

• A fixed payment, many bonds make

15-yr. Bond Bank Account

Yearly payment of To obtain same yearly

• A stock is a certificate that certifies

• When a firm issues new shares of

• Stockholders have a right to select

• Unlike bonds or direct borrowing,

• A capital gain is an increase in the

• A realized capital gain occurs when

• Most stocks bought and sold on the

• Things that are likely to affect the

• The amount by which future

• The amount by which future

• Thus we can say that the price of a

• Announcements of higher expected

• The price of a stock may also be

• One might call this a bubble because

• Dow Jones Industrial Average

• NASDAQ Composite Index:

• Standard and Poors 500 (S&P 500)

• From a macroeconomic perspective,

• A better measure of the market value

• Between 1995 and 2000, the S&P

• This is by far the largest stock

• The stock market boom cannot be

• Millions of lives were affected by the

• An increase in stock prices causes

• Investment is also affected by higher

• The value of stocks in the United

• If the multiplier is 1.4, the $1 trillion

• However, as the life-cycle theory of

• The stock market crash of 1987 did

• Since the initial decrease in wealth

• The boom in the economy between

• Estimates show that had there been

• The value of stocks increased by

• Had there been no

• Had there been no

• Had there been no

• Had there been no

• Had there been no

• Had there been no

• Had there been no

• This figure shows that

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