How does the stock market affect the economy?

The London Stock market has a market capitalisation of US$3.266 trillion (2011). Movements in the stock market can have a profound economic impact on the economy and everyday people. A collapse in share prices has the potential to cause widespread economic disruption. Most famously, the stock market crash of 1929 was a key factor in causing the great depression of the 1930s. Yet, daily movements in the stock market can also have less impact on the economy than we might imagine. During the great recession of 2009-13, the stock market performed quite strongly. This rise in share prices was rather misleading to the state of the economy. Also, a fall in share prices doesn’t necessarily cause an economic downturn. There is a saying

Stock markets have predicted 10 out of the last 3 recessions.

For example, the stock market crash of 1987, didn’t cause any lasting economic damage. (though it did influence monetary policy. UK cut interest rates in fear the stock market crash would cause a recession. Instead, low interest rates caused a boom.

Plummeting share prices can make headline news. But, how much should we worry when share prices fall? How does it impact on the average consumer? and how does it affect the economy?

Economic Effects of the Stock Market

1. Wealth Effect

The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses. The wealth effect is more prominent in the housing market.

2. Effect on Pensions

Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence

Often share price movements are reflections of what is happening in the economy. E.g. a fear of a recession and global slowdown could cause share prices to fall. The stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor. However, there are times when the stock market can appear out of step with the rest of the economy. In the depth of a recession, share prices may rise as investors look forward to a recovery two years in the future.

4. Investment

Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

 

5. Bond Market

A fall in the stock market makes other investments more attractive. People may move out of shares and into government bonds or gold. These investments offer a better return in times of uncertainty. Though sometimes the stock market could be falling over concerns in government bond markets (e.g. Euro fiscal crisis)

 

 

How does the Stock Market affect ordinary people?

Most people, who do not own shares, will be largely unaffected by short term movements in the stock market. However, ordinary workers are not completely unaffected by the stock market.

1. Pension funds. Many private pension funds will invest in the stock market. A substantial and prolonged fall in the stock market could lead to a fall in the value of their pension fund, and it could lead to lower pension payouts when they retire.¬†Similarly, if the stock market does well, the value of pension funds could increase. Even if people don’t own shares, it is quite likely people with a private pension will have some connection to the stock market.

2. Business investment. The stock market could be a source of business investment, e.g. firms offering new shares to finance investment. This could lead to more jobs and growth. The stock market can be a source of private finance when bank finance is limited. However, the stock market is not usually the first source of finance. Most investment is usually financed through bank loans rather than share options. The stock market only plays a limited role in determining investment and jobs.

3. Short-termism. It could be argued workers and consumers can be adversely affected by the short-termism that the stock market encourages. Shareholders usually want bigger dividends. Therefore, firms listed on the stock market can feel under pressure to increase short-term profits. This can lead to cost cutting which affects workers (e.g. zero contract hours) or the firm may be more tempted to engage in collusive practises which push up prices for consumers. It has been argued that UK firms are more prone to short-termism because the stock market plays a bigger role in financing firms. In Germany, firms are more likely to be financed by long-term loans from banks. Typically, banks are more interested in the long-term success of firms and are willing to encourage more investment, rather than short-term profit maximisation.

 

31 Responses to How does the stock market affect the economy?

  1. Tony Montana June 26, 2008 at 10:14 am #

    “There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

    That does not make sense – how can you predict 10 out of 3? Did you mean 3 out of 10?

    Any way scare mongering can affect the ecomony but the average Joe Smuch just heres about it but carries on as normal.

    • will November 26, 2013 at 2:55 am #

      lol dude think about it,

      the saying means that the stock market shoots up and down for no reason.

      So it will shoot down, and “predict” a recession, but it’s just BS so it never actually happens.

      It shows how the stock market can cause panic for no reason.

      get it?

  2. Bob Tan January 5, 2009 at 8:33 pm #

    I don’t get how these are essays!

  3. hannah montana January 29, 2009 at 7:59 pm #

    i love the stock market lets mess up this world even more than bush did!!!!

  4. mya March 24, 2009 at 5:03 pm #

    how does consumers affect the market economy?

  5. bell direct September 9, 2009 at 5:26 pm #

    Stock market has a big effect on our economy. Stock market shows the gross national product of a country. That’s how important a stock is in the economy.

  6. Chicken October 23, 2009 at 5:34 pm #

    The stock maket is a tasty way to get your hands on some money however when the economy breaks down. Everybody looses there way and panics. for example. If the was a large shortage in chickens everyone would panic becuase chickens are loved by most people as is money

  7. VARSHA GOME January 4, 2010 at 2:52 pm #

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  8. MANOJ KHEDE January 4, 2010 at 3:15 pm #

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  9. Nisha February 22, 2010 at 7:41 pm #

    Why are financial markets important to the health
    of an economy?

    • mercy chomba January 20, 2014 at 12:39 am #

      Nisha, of course financial markets contribute to the economic growth of the country thus contributing to the GDP,

  10. john March 2, 2010 at 1:26 pm #

    has bush or any one else has anything to do with the economic crisis.kindly answer iam quite new to this and i want to become an entrepreneur U R suggestions about what should i do are most awaited n welcome

  11. henry@penny stock March 20, 2010 at 1:11 pm #

    Stock market is having quite a lot of effect of economy and its reversal is also try.
    Right now I am just a beginner and learning this stuff..

  12. stock trading newsletter July 14, 2010 at 2:24 pm #

    I think that wealth effect and the condfidence are the most important currently.

  13. Confused Person October 26, 2010 at 6:41 pm #

    I’m confused. Whatever people are doing now, you are doing it wrong! All people talk about is how the econmy sucks, soooo change it.

    Goodbye

  14. arunima April 8, 2011 at 2:00 pm #

    how does it effect

    • derp January 12, 2012 at 8:51 pm #

      it doesnt

  15. Madhusudan Yeole August 18, 2011 at 4:35 am #

    I want to know the basic principle behind the working of hare market? What is the profit, company is getting from shares? Does the downfall in share price affect the overall performance of the company?

  16. blogaof September 1, 2011 at 5:22 pm #

    Thank You Why are financial markets important to the health

  17. sadia business@@ January 25, 2012 at 7:44 am #

    oh my god stock xchng effect to much.astonishing

  18. jahri September 13, 2012 at 1:45 am #

    if you really know or knowledgeably enough on how to invest in the different market,you dont have to worry, you push your money to the fullest and high ROI. Big players in the marketsas wellas other investors are make there moneybut one thing dont sell your securities immediately hold it for a long time and sell it, its because evry now and then prices are increases.

  19. Jack Rubio December 11, 2013 at 1:56 pm #

    Great read-A lot of things from the stock market surprisingly affect the economy

  20. mercy January 20, 2014 at 12:48 am #

    Am just starting to study about the stock markets and am enjoying, of course stock markets affect the economy in so many ways but as economists watcha doing about it??

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