Why Policymakers Might Care about Stock Market Bubbles

By Gomme, Paul | Economic Commentary (Cleveland), May 15, 2005 | Go to article overview

Why Policymakers Might Care about Stock Market Bubbles


Gomme, Paul, Economic Commentary (Cleveland)


On the face of it, it's somewhat perplexing that variations in the stock market should have effects on the macroeconomy more generally. After all, on each side of a stock market transaction is a buyer and a seller; the sale of stock by one individual corresponds to the transfer of ownership of a small piece of a firm to another individual. Following such a transaction, the firm can continue to produce the same goods and services since all the employees still work for the firm, the firm still owns the same plant and equipment, and the particular ways of utilizing these inputs are still known.

But the stock market's ups and downs can have very real, if not direct, effects on the macroeconomy. Stock market bubbles are a case in point. The inevitable crash that follows a bubble has the potential to cause recessions-the Great Depression being the worst case example of that connection to date. The mere possibility of repeating an episode so destructive warrants policymakers' interest in the behavior of the stock market, even though the link between the stock market and the macroeconomy may not be well understood. Indeed, there is continuing debate within the economics profession over the exact causes of the Great Depression, as well as the factors that led to its severity and duration. We should also keep in mind that the link between the stock market and the macroeconomy is not very tight. As Paul Samuelson quipped, the stock market has predicted nine of the last five recessions. Perhaps the lack of a tight connection between the stock market and the macroeconomy is a positive development, particularly if we think that policymakers have managed to insulate the macroeconomy somewhat from stock market fluctuations.

If there isn't much of a link between the stock market and the supply side of the economy (the ability of the economy to produce goods and services), then perhaps there is one between the stock market and the demand side (the influences on demand for goods and services). Two likely candidates present themselves: consumption and investment. The next section briefly examines the consumption channel and finds that it simply isn't big enough. We then examine the more promising channel of investment. We consider a particular theory of investment (known to economists as Tobin's q), but the crux of the argument is that stock market prices serve as a signal to firms' managers to buy new investment goods. We will see that a stock market crash can very quickly lead to a reduction in investment, and so a recession. Further, we will see that such investment-triggered recessions may be long-lived.

* Wealth Effects

One reason that fluctuations in stock prices may affect the macroeconomy is that individuals who hold stocks, either directly or indirectly (for example, through mutual funds or pension plans), feel poorer when the stock market falls. This wealth effect causes people to cut back on their consumption, a major component of aggregate demand.

How big might these wealth effects be? Consider what happened during the stock market decline that began in the first quarter of 2000 and ended in the third quarter of 2002. Over this period, the combined market capitalization of the NASDAQ and NYSE fell from 1.9 times GDP to 1 times GDP. Such a fall in market wealth is estimated to have caused a reduction in consumption of 0.36 percent of GDP. (This figure is calculated using a reasonable estimate of the degree to which U.S. consumers change their consumption when their wealth changes-known as the "marginal propensity to consume out of wealth"-of 4 percent. That is, for every $100 decline in wealth, the estimate suggests that U.S. consumers lower their consumption by $4.) Put differently, we would expect GDP growth to be 0.36 percentage points lower than it would have been had the stock market capitalization stayed at 1.9 times GDP.

While 0.36 percentage points of growth over 10 quarters is nothing to sneeze at, it certainly is not a disaster. …

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