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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 Fair Karl Case, Ray Fair

The Stock Market

and the Economy

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

The Stock Marketand the Economy

The stock market boom of the lasthalf 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 newage?

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Stocks and Bonds

To make a large purchase, a firmcan borrow the funds from a bank,

but it can also issue a bond. A bondis a document that formally

promises to pay back a loan underspecified terms and a given period oftime.

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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 bondbefore maturity).

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Bonds


A fixed payment, known as a coupon,

calculated using the prevailing interestrate at the time of issue.

The bondholder receives a set amount,known in advance, no matter what happensto 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 thepriceof the bondthat changes.

The bond is worth less when interestrates 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 stockis a certificate that certifiesownership 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 additionalowners who supply it with funds.

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Stocks

Stockholders have a right to selectthe management of the firm and to

share in its profits. Unlike bonds or direct borrowing,

stocks do not promise a fixed annualpayment. Returns depend oncompany performance. If profits arehigh, the firm may pay dividends.

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Stocks

A capital gain is an increase in thevalue of an asset.

A realized capital gain occurs whenthe owner of an asset actually sells itfor more than he paid for it.

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Stocks

Most stocks bought and sold on thestock market daily are not newly

issued but issued long ago, when thefirm goes public.

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Determining the Price of a Stock

Things that are likely to affect theprice of a stock include:

What people expect its future dividendswill be

When the dividends are expected to bepaid

The amount of risk involved

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The amount by which futuredividends are discounted depends

on the interest rate. The larger theinterest rate, the more will expectedfuture dividends be discounted.

Interest rate 10% 5%

Amount today $100 $104.76

Pays one yearfrom now $110 $110

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The amount by which futuredividends are discounted is greater

when the possibility of obtainingdividends from a firm is moreuncertain.

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Thus we can say that the price of astock should equal the discounted

value of its expected futuredividends, where the discount factorsdepend on the interest rate and risk.

Announcements of higher expectedfuture dividends or perceived lowerrisk should increase the firms stockprice.

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The price of a stock may also bedriven up not by the discounted

value of expected future dividends,but by peoples views of what otherswill pay for the stock in the future.

One might call this a bubble becausethe stock price depends on whatpeople expect that other peopleexpect, etc.

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The Stock Market Since 1948

Dow Jones Industrial AverageIndex:

An index based on the stock prices of30 actively traded large companies.The oldest and most widely followedindex 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 theNASDAQ stock market. The NASDAQmarket takes is name from the NationalAssociation of Securities DealersAutomated Quotation System.

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Standard and Poors 500 (S&P 500)Index:

An index based on the stock prices ofthe largest 500 firms traded on the NewYork Stock Exchange, the NASDAQstock market, and the American Stock

Exchange.

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From a macroeconomic perspective,the Dow Jones Industrial Average

and the NASDAQ index cover toosmall a sample of firms.

A better measure of the market valueof all firms in the economy is theStandard and Poors 500 stock priceindex, 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&P500 index rose 226 percent, an

annual rate of 25 percent! This is by far the largest stock

market boom in U.S. history. Thisboom added $14 trillion to household

wealth, about $2.5 trillion per year.

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The stock market boom cannot beexplained by a large fall in interest

rates, higher profits, or a fall in theperceived riskiness of stocks. Thisled many people to the view that itwas simply a bubble.

Millions of lives were affected by theeuphoria of the boom and thecorrection 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 causesan increase in wealth, and

consequently an increase inconsumer spending.

Investment is also affected by higherstock prices. With a higher stock

price, a firm can raise more moneyper share to finance investmentprojects.

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The Crash of October 1987

The value of stocks in the UnitedStates fell by about a trillion dollars

between August 1987 and the end ofOctober 1987.

If the multiplier is 1.4, the $1 trillion

decrease in wealth in 1987 implies a$40 billion lower level of spending in1988, or about 1.4 percent ofGDP.

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However, as the life-cycle theory ofconsumption predicts, households

smooth their consumption over time,which means that the decrease inwealth would not have reducedconsumption in the current year by

the full amount of the decrease inwealth, but by cutting consumption alittle each year.

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The stock market crash of 1987 didnot result in a recession in 1988

because households and businessfirms did not lower their expectationsdrastically.

Since the initial decrease in wealthturned out to be temporary, thenegative wealth effect was not aslarge as anticipated.

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The Boom of 1995-2000

The boom in the economy between1995 and 2000 was fueled by thestock market boom.

Estimates show that had there beenno stock market boom the economywould not have looked historically

unusual in the last half of the 1990s.

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The value of stocks increased byabout $2.5 trillion per year during theboom.

Assuming that a $1 increase in stockprices leads to a $0.04 increase inconsumption and investment, and amultiplier of 1.4, then:

0.04 x $2.5 trillion x 1.4 = $140 billionincrease in GDP, or 1.5% of GDP.

The growth rate of GDP would havebeen around 2.8% instead of 4.5%

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Personal Saving Rate,1995 I 2002 III

Had there been noboom:

The personal savingrate would have beenhigher.

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Investment Output Ratio,1995 I 2002 III


Firms would haveinvested less in plantand equipment.

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Ratio of Federal Government BudgetSurplus to GDP, 1995 I 2002 III


The federalgovernment surpluswould not have beenas high, since taxableincome and profitswould have been less.

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There would havebeen no stock marketcorrection in 2001 and2002, and the growthrate of real GDP wouldhave been higher.

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The Unemployment Rate,1995 I 2002 III


The unemploymentrate would haveremained at about 5.5percent. It was 4%during the boom.

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Inflation Rate, 1995 I 2002 III


Inflation would havebeen lower due to lessdemand pressure.

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3-Month Treasury Bill Rate,1996 I 2002 III


The 3-month Treasurybill rate and interestrates as a whole wouldhave been lower.

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Fed Policy and the Stock Market

This figure shows thatthe Fed is influencedby the stock market.

The Fed cares aboutthe stock market to theextent that the market

affects the things thatit ultimately caresabout, namely output,unemployment, andinflation.

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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 41 of 41

Key Terms and Concepts

bondbond

capital gaincapital gain

Dow Jones Industrial Average IndexDow Jones Industrial Average Index

NASDAQ Composite IndexNASDAQ Composite Index

realized capital gainrealized capital gain

Standard and Poors 500 (S&P 500) IndexStandard and Poors 500 (S&P 500) Indexstockstock

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Case Fair 28

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