KW_Macro_Ch_09_Sec_03_Financial_Fluctuations

KW_Macro_Ch_09_Sec_03_Financial_Fluctuations - chapter 9 >...

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>> Savings, Investment Spending, and the Financial System Section 3: Financial Fluctuations chapter 9 We’ve learned that the financial system is an essential part of the economy; without stock markets, bond markets, and banks, long-run economic growth would be hard to achieve. Yet the news isn’t entirely good: the financial system sometimes doesn’t func- tion well and instead seems to be a source of instability. For evidence, we need look no further than the pivotal event of modern macroeconomics, the Great Depression. The worst economic slump in American history is closely identified with the U.S. stock mar- ket crash of 1929. And the 2001 U.S. recession was preceded by a sharp decline in stock prices in 2001. In Chapter 10 we’ll learn about the channel by which changes in stock prices influence macroeconomic performance—how changes in households’ wealth caused by asset market fluctuations alter their demand for goods and services. We could easily write a whole book on asset market fluctuations. In fact, many people have. Here, we briefly discuss the causes of stock price fluctuations.
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The Demand for Stocks Once a company issues shares of stock to investors, those shares can then be re-sold to other investors in the stock market. And these days, thanks to cable TV and the Internet, you can easily spend all day watching stock market fluctuations—the move- ment up and down of the prices of individual stocks as well as the indexes. These fluc- tuations reflect supply and demand by investors. But what causes the supply and demand for stocks to shift? Remember that stocks are financial assets: they are shares in the ownership of a com- pany. Unlike a good or service, whose value to its owner comes from its consumption, the value of an asset comes from its ability to generate higher future consumption of goods or services. A financial asset allows higher future consumption in two ways. It can generate future income through paying interest or dividends. But most stocks don’t pay dividends, instead retaining their earnings to finance future investment spending. Investors purchase non-dividend-paying stocks in the belief that they will earn future income from selling the stock in the future at a profit, the second way of generating higher future income. Even in the cases of a bond or a dividend-paying stock, investors will not want to purchase an asset that they believe will sell for less in the future than today because such an asset will reduce their wealth when they sell it. So the value of a financial asset today depends on investors’ beliefs about the future value or price of the asset. That is, if investors believe that it will be worth more in the future, they will
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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KW_Macro_Ch_09_Sec_03_Financial_Fluctuations - chapter 9 >...

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