EFFECT OF STOCK MARKET PERFORMANCE TO THE ECONOMY

The swings of the stock market affect the personal finances of investors who own stocks, but do the swings affect the broader economy? Economists believe that fluctuations in stock prices can affect the economy by affecting the spending of households and firms.

Rising stock prices can lead to increased spending, and falling stock prices can lead to decreased spending. Increases in spending can lead to increases in production and employment, while decreases in spending can lead to decreases in production and employment.

The effect of changes in stock prices on spending occurs through several channels.

First, large corporations use the stock market as an important source of funds for expansion. Higher stock prices make it easier for firms to fund spending on real physical investments such as factories and machinery, or on research and development, by issuing new stock.

Lower stock prices make it more difficult for firms to finance this type of spending. Second, stocks make up a significant portion of household wealth. When stock prices rise, so does household wealth, and when stock prices fall, so does household wealth.

For example, the increase in stock prices between 1995 and 2000 increased wealth by $9 trillion, while the decline in stock prices between 2000 and 2002 wiped out $7 trillion in wealth. Similarly, the fall in stock prices between the fall of 2007 and the spring of 2009 wiped out $8.5 trillion in wealth.

Households spend more when their wealth increases and less when their wealth decreases. So, fluctuations in stock prices can have a significant impact on the consumption spending of households.

Finally, the most important consequence of fluctuations in stock prices may be their effect on the expectations of consumers and firms. Significant declines in stock prices are typically followed by economic recessions.

Consumers who are aware of this fact may become more uncertain about their future incomes and jobs when they see a large fall in stock prices. Christina Romer, an economist at the University of California, Berkeley, and former chair of the Council of Economic Advisers in the Obama administration, has argued that the stock market crash of 1929 played an important role in bringing on the Great Depression of the 1930s.

Romer argues that the crash increased uncertainty among consumers about their future incomes, which caused them to significantly reduce spending on consumer durables, such as automobiles, furniture, and appliances.

These spending declines led to production and employment declines in the affected industries, which worsened the economic downturn that had already begun. By increasing uncertainty, fluctuations in stock prices can also cause firms to postpone spending on physical investment.