Stock Prices and Output Growth: An Examination of the Credit Channel

By Carlstrom, Charles T.; Fuerst, Timothy S. et al. | Economic Commentary (Cleveland), August 15, 2002 | Go to article overview

Stock Prices and Output Growth: An Examination of the Credit Channel


Carlstrom, Charles T., Fuerst, Timothy S., Ioannidou, Vasso P., Economic Commentary (Cleveland)


When stock market values fall, we know it means investors expect lower economic growth in the future. But can stock market declines actually affect future growth? There is some evidence that they can-through the credit channel.

With the economy still officially in a recession since March 2001, all eyes are on the stock market to help answer how quickly we will rebound from the current slowdown. The reason the stock market receives such attention is that it is considered a leading indicator of future economic activity. Recessions are characterized by sharp falls in equity prices, and these typically precede slower economic growth by approximately two quarters (see figure 1). If we used the stock market as our crystal ball, albeit a very cloudy one, we would be concerned that the recession might not be over. The stock market seemed to recover during the last quarter of 2001 -by the beginning of 2002, the S&P 500 had risen

over 20 percent from its low on September 21. Since then, however, that gain has been erased, and the market is lower than it has been since 1997.

But why should stock prices and future real GDP growth be related? This Economic Commentary examines two prominent explanations for why stock market values and real GDP figures move together. The first explanation says that changes in information about the future course of real GDP may cause prices to change in the stock market today. This explanation suggests that, while stock prices are used to predict future economic activity, the actual causality is from future GDP growth (that is, the prediction of it) to current stock prices. The other explanation for the linkage between the stock market and real GDP growth is that changes in stock prices, no matter what the source, will reduce firms' asset positions and affect the cost of their borrowing. When it costs more for firms to borrow money, they borrow and invest less, and when firms invest less, real GDP growth slows. According to this view-referred to by some as balance-sheet effects and others as the credit channel stock prices will change because of changes in real economic conditions or some other factor, but the credit channel may impact the severity and length of recessions.

* Correlation Does Not Imply

Causality: Stock Prices and

Real GDP

While movements in stock prices precede movements in GDP, it doesn't prove that stock price movements cause changes in real GDP growth. In fact, the causality may go the other way. Stock prices reflect the fundamental value of the firm-the present discounted value of future firm earnings, so, by definition, they incorporate forecasts of future economic activity. Investors who expect future GDP growth to slow may lower stock prices today. But just as we wouldn't conclude that commuters cause afternoon rain because they decided to carry an umbrella to work after hearing the morning weather report, we can't conclude that when stock prices change today, this causes future GDP growth to change.

This implies that a fall in the stock market, if caused by some factor that does not affect economic growth directly, might not say anything about future GDP. For example, suppose that the weakness in the stock market at the beginning of 2002 was caused by general accounting worries in the aftermath of Enron's collapse and is not directly related to forecasts of future GDP growth. A fall in the stock market for this reason might be bad for your 401 (k)s but is not indicative of future low GDP growth.

There is reason to believe, however, that a decline in stock prices can have a dampening effect on real GDP growth and, in fact, cause real GDP growth to fall. The next section explains how this dampening effect works and examines the evidence for it.

* Firm Balance Sheet Effects A decline in stock prices can dampen future GDP growth through the credit channel because debt is costly. Companies raise money either by issuing additional stock or by borrowing from a bank or the public. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Stock Prices and Output Growth: An Examination of the Credit Channel
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.