Stock Market And The Economy
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Stock Market And The Economy

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Stock Market And The Economy Stock Market And The Economy Presentation Transcript

  • : 82 R E T P A H C •The STock MarkeT and The econoMy © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 1 of 41
  • The Stock Market and 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 : 82 R E T P A H C age? © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 41
  • Stocks and Bonds : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 41
  • Bonds • Bonds have several properties: • Face value, or the amount the buyer : 82 R E T P A H C agrees to lend to the bond issuer © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 4 of 41
  • Bonds • Bonds have several properties: • Maturity date, or the date when the : 82 R E T P A H C funds are paid back to the lender (although the lender may sell the bond before maturity). © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 5 of 41
  • Bonds • Bonds have several properties: • A fixed payment, known as a coupon, calculated using the prevailing interest rate at the time of issue. • The bondholder receives a set amount, : 82 R E T P A H C known in advance, no matter what happens to interest rates, stock prices, and so on. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 41
  • Bonds • Bonds have several properties: • 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 : 82 R E T P A H C rates rise. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 7 of 41
  • Bonds 15-yr. Bond Bank Account Face Value: $10,000 Coupon rate: 10% requires only: $5,000 with interest rate of 20% : 82 R E T P A H C Yearly payment of $1,000 © 2004 Prentice Hall Business Publishing To obtain same yearly payment of $1,000 Principles of Economics, 7/e Karl Case, Ray Fair 8 of 41
  • Stocks : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 41
  • Stocks : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 41
  • Stocks • A capital gain is an increase in the value of an asset. : 82 R E T P A H C • A realized capital gain occurs when the owner of an asset actually sells it for more than he paid for it. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 41
  • Stocks : 82 R E T P A H C • Most stocks bought and sold on the stock market daily are not newly issued but issued long ago, when the firm “goes public.” © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 41
  • 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 : 82 R E T P A H C paid • The amount of risk involved © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 41
  • Determining the Price of a Stock • 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. 10% Amount today : 82 R E T P A H C Interest rate $100 $104.76 Pays one year from now $110 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e 5% $110 Karl Case, Ray Fair 14 of 41
  • Determining the Price of a Stock : 82 R E T P A H C • The amount by which future dividends are discounted is greater when the possibility of obtaining dividends from a firm is more uncertain. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 15 of 41
  • Determining the Price of a Stock : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 16 of 41
  • Determining the Price of a Stock : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 17 of 41
  • The Stock Market Since 1948 • Dow Jones Industrial Average Index: • An index based on the stock prices of : 82 R E T P A H C 30 actively traded large companies. The oldest and most widely followed index of stock market performance. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 18 of 41
  • The Stock Market Since 1948 • NASDAQ Composite Index: • An index based on the stock prices of : 82 R E T P A H C 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 19 of 41
  • The Stock Market Since 1948 • Standard and Poors 500 (S&P 500) Index: • An index based on the stock prices of : 82 R E T P A H C the largest 500 firms traded on the New York Stock Exchange, the NASDAQ stock market, and the American Stock Exchange. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 20 of 41
  • The Stock Market Since 1948 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 21 of 41
  • : 82 R E T P A H C The S&P 500 Stock Price Index, 1948 I – 2002 III © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 22 of 41
  • The Stock Market Since 1948 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 23 of 41
  • The Stock Market Since 1948 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 24 of 41
  • : 82 R E T P A H C Growth Rate of S&P 500 Earnings, 1948 I – 2002 III © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 25 of 41
  • : 82 R E T P A H C Ratio of Profits to GDP, 1948 I – 2002 III © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26 of 41
  • Stock Market Effects on the Economy : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 27 of 41
  • The Crash of October 1987 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28 of 41
  • : 82 R E T P A H C The Crash of October 1987 • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29 of 41
  • The Crash of October 1987 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 30 of 41
  • The Boom of 1995-2000 : 82 R E T P A H C • 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 31 of 41
  • The Boom of 1995-2000 • The value of stocks increased by about $2.5 trillion per year during the boom. • Assuming that a $1 increase in stock : 82 R E T P A H C 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% © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 32 of 41
  • Personal Saving Rate, 1995 I – 2002 III • Had there been no boom: • The personal saving : 82 R E T P A H C rate would have been higher. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 33 of 41
  • Investment Output Ratio, 1995 I – 2002 III • Had there been no boom: • Firms would have : 82 R E T P A H C invested less in plant and equipment. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34 of 41
  • Ratio of Federal Government Budget Surplus to GDP, 1995 I – 2002 III • Had there been no boom: : 82 R E T P A H C • The federal © 2004 Prentice Hall Business Publishing government surplus would not have been as high, since taxable income and profits would have been less. Principles of Economics, 7/e Karl Case, Ray Fair 35 of 41
  • The Boom of 1995-2000 • Had there been no boom: : 82 R E T P A H C • There would have © 2004 Prentice Hall Business Publishing been no stock market correction in 2001 and 2002, and the growth rate of real GDP would have been higher. Principles of Economics, 7/e Karl Case, Ray Fair 36 of 41
  • The Unemployment Rate, 1995 I – 2002 III • Had there been no boom: • The unemployment : 82 R E T P A H C rate would have remained at about 5.5 percent. It was 4% during the boom. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 37 of 41
  • Inflation Rate, 1995 I – 2002 III • Had there been no boom: • Inflation would have : 82 R E T P A H C been lower due to less demand pressure. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38 of 41
  • 3-Month Treasury Bill Rate, 1996 I – 2002 III • Had there been no boom: • The 3-month Treasury : 82 R E T P A H C bill rate and interest rates as a whole would have been lower. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 39 of 41
  • Fed Policy and the Stock Market • This figure shows that the Fed is influenced by the stock market. : 82 R E T P A H C • The Fed cares about © 2004 Prentice Hall Business Publishing the stock market to the extent that the market affects the things that it ultimately cares about, namely output, unemployment, and inflation. Principles of Economics, 7/e Karl Case, Ray Fair 40 of 41
  • Key Terms and Concepts bond capital gain Dow Jones Industrial Average Index NASDAQ Composite Index realized capital gain : 82 R E T P A H C Standard and Poors 500 (S&P 500) Index stock © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 41 of 41