Many believe the stock market is the backbone and mirror of a country’s economic progress. Others believe that stock market movements cause psychological changes by alerting businesses to the need to downsize or expand. Some economists believe that a stock market crash reduces consumer spending. As a result, economic growth has slowed.
Why Do We Have a Stock Market?
A stock is a type of security representing an individual’s ownership of a company, and a stock market is a marketplace where investors can buy and sell such assets.
The stock market exists for two primary reasons. The first is to allow a company to raise capital that can be used to expand and grow the business. If a company issues one crore shares at Rs 4 per share, it can raise Rs 4 crore for the business.
Companies prefer this method of raising capital because it allows them to avoid incurring debt and paying high-interest rates. The stock market also allows investors to share in a company’s profits.
Understanding How the Stock Market Affects GDP
Before determining how markets affect GDP, we must examine what drives economic growth. The GDP of the US economy is primarily driven by spending and investment.
GDP is usually expressed as a percentage growth rate from one period to the next. So, for example, if the quarter-to-quarter growth rate is 2%, the US economy grew by 2% annually in that quarter.
GDP’s key components include:
- Consumer spending is the primary driver of GDP in the United States.
- Exports are sales made by domestic companies to customers in other countries.
- Purchases of new plants and equipment, hiring, investment in new technologies, and construction of new offices and factories are all examples of business spending.
- Government spending includes road construction, bridge construction, and subsidies to industries such as agriculture.
How Bull Markets Affect GDP
A bull market occurs when equity markets rise. The stock market primarily impacts GDP by influencing financial conditions and consumer confidence. When stocks are rising—when they are in a bull market—there is a lot of optimism about the economy and the prospects of various stocks.
Companies that issue new stock to raise capital can use the proceeds to expand operations, invest in new projects, and hire more workers. All of these activities contribute to GDP growth. Moreover, it’s easier for companies to issue new shares during a bull market since there’s a healthy demand for equities.
If GDP is rising, indicating that the economy is doing well, those same companies can raise additional funds by borrowing from banks or issuing new debt, known as bonds. Investors purchase the bonds, and the funds are used for business expansion and growth, thereby increasing GDP.
With rising stock prices, investors and consumers have more wealth and are more optimistic about the future. This optimism leads to increased spending and large purchases such as homes and automobiles. As a result, corporations’ sales and earnings rise, contributing to an increase in GDP.
How Bear Markets Affect GDP
When the stock market falls—a bear market—it means that stock prices are falling, which can harm sentiment. As a result, investors rush to sell stocks during a bear market to protect their investments from losses. Typically, those losses lead to decreased consumer spending, especially if a recession looms. Two consecutive quarters of negative—or contracting—GDP growth is frequently used to define a recession.
When consumers reduce their spending, companies’ sales and revenues suffer. Companies are then forced to cut costs and employees. In addition, the decline in consumer spending is exacerbated by rising unemployment and increased uncertainty about the future.
What Are the 4 Types of GDP?
The four types of GDP are
- real GDP, which is GDP adjusted for inflation,
- actual GDP, which is GDP calculated for the current moment in time, and
- nominal GDP, which is GDP with inflation,
- potential GDP, which is what GDP could be under ideal economic conditions.
What Is the Importance of GDP?
GDP is significant because it measures the performance of various economic sectors, such as consumption and investment, and serves as an indicator of an economy’s health. A rising GDP indicates a healthy economy where people are employed and businesses expand.
Reasons why stock exchanges affect the economy
Effects of Consumer Activity
Sharp changes in consumer activity directly impact corporate profits and, as a result, stock prices. Consumer confidence is important in this case because a confident consumer spends more. Therefore, stock prices reflect consumer expectations for the future when markets rise. Furthermore, increased consumer confidence leads to higher retail sales and more favourable shopping habits.
Consumers with disposable income are also more likely to invest in real estate, particularly housing, which is another important economic indicator. Therefore, data from the real estate sector can help market participants determine whether people are willing to make large investments in real estate.
Aside from economic indicators, investor activity measures are excellent market indicators for participants. Contrary to popular belief, bearish conditions are ideal for investing rather than bullish conditions. The latter raises prices and necessitates an examination of investor sentiment. As NRI investments in India continue to grow and the central bank purchases more treasuries, interest rates frequently fall, pushing stock prices higher.
On the other hand, less buying depresses stock prices when interest rates are high. It is also wise to pay attention to market indicators such as decline/advance ratios and the total number of highs and lows recorded by the market. These reflect the stock market’s overall health and confirm the “quality” of the market’s rise or fall.
Impact on Business Investment
When stock prices are high, businesses are more likely to make capital investments due to the high market values. Many companies issue initial public offerings (IPOs) during this period because market optimism is high, and it is a good time to raise capital by selling shares. During a bull market, there are also more mergers and acquisitions, and companies can use the value of their stock to buy out other companies. As a result, increased investment leads to increased economic growth.
When the stock market is down, investment suffers as a result. Businesses are less eager to invest in the economy as confidence in it declines. In addition, the drop in share price makes it more difficult for companies to raise capital on the stock market.
Consumption and the Wealth Effect
When stock prices rise and there is a bull market, people become more confident in market conditions and increase their investments. As a result, they are more likely to spend money on expensive items such as houses and cars. This is also known as the wealth effect, which describes how a change in a person’s income affects their spending habits and, as a result, leads to economic growth.
There is a negative wealth effect when there is a bear market or a drop in stock prices. It creates an uncertain environment for consumers, and a decline in the value of their investment portfolios reduces spending on goods and services. This impacts economic growth because consumer spending accounts for a large portion of GDP.
Inflation Determines Stock Market Movement
The Reserve Bank of India promotes and monitors the country’s price stability and economic growth. Price stability can be measured by the rate of inflation change, which significantly impacts the RBI’s monthly monetary policies. The Consumer Price Index, or CPI, is the primary indicator of inflation and measures changes in the prices of consumer goods. It is a metric for determining the increase in living expenses that must be borne by average consumers.
The PPI, or Producer Price Index, measures inflationary changes in producer goods prices. If these continue to rise significantly, manufacturers will likely pass on the price increase to consumers, influencing their behaviour.
Oil price fluctuations significantly impact the global economy because oil is a principal key indicator of economic progress and activity. As a result, sudden increases in oil prices usually harm most economies that rely on them. In addition, increased oil prices drive up the prices of many consumer goods due to the higher transportation costs.
Inflation can also be used to determine the value of a company. As inflation rises, the discount rate lowers the project value. Alternatively, deflation is risky because it leads to decreased revenue and future layoffs for firms unable to maintain full workforces. Lower corporate valuation hurts global stock markets.
The Employment Factor
Employment, as a major indicator of a country’s economic progress, has a significant impact on both stock and bond markets, particularly when a country’s monthly employment and unemployment statistics are released. In addition, the employment situation also influences consumer sentiment and confidence, affecting market performance.
It goes without saying that the state of the labour market significantly impacts the economy’s well-being. This implies that a weak labour market may result in lower corporate profits. This is based on the assumption that with rising unemployment, people cannot invest in homes or make necessary purchases that drive corporate profits.
How does the stock market affect ordinary people?
Short-term stock market movements will be largely unaffected by most people who do not own stock. On the other hand, Ordinary workers are still unaffected by the stock market.
- Pension plans.
Many private pension funds will make stock market investments. A significant and prolonged drop in the stock market could cause a drop in the value of their pension fund, resulting in lower pension payouts when they retire. Likewise, if the stock market performs well, the value of pension funds may rise. Even if people do not own shares, they likely have some exposure to the stock market through their private pension.
However, most shares are owned by the top 10% of income owners. According to this paper on middle-class wealth, the poorest 90% of income earners own only 7% of all equity. As a result, a drop in stock prices primarily affects the top 10% of wealthy households.
The stock market encourages short-termism, which harms workers and consumers. Dividends are typically desired by shareholders. As a result, publicly traded companies may feel pressure to increase short-term profits. This can result in cost-cutting that affects workers, or the firm may be more tempted to engage in collusive practices that raise consumer prices.
It has been argued that because the stock market plays a larger role in financing firms, UK firms are more prone to short-termism. On the other hand, firms in Germany are more likely to be financed by long-term bank loans. Banks are typically more concerned with a firm’s long-term success and are willing to encourage more investment rather than short-term profit maximisation.
- Business investment.
The stock market could be a source of business investment, e.g. firms offering new shares to finance investment. This could result in more jobs and economic growth. In addition, when bank financing is limited, the stock market can be a source of private finance. The stock market, however, is not usually the first source of finance. Most investments are typically financed through bank loans rather than stock options. As a result, the stock market has a limited impact on investment and job creation.
Contrary to popular belief, the stock market and the economy are not the same things. An economy’s GDP and stock market gains are incompatible, and there is little comparison between the two.
The main reason for this disparity is the size difference between the two markets. The economy is influenced by millions of positive and negative factors, whereas the stock market is influenced by only one factor: stock supply and demand.
For stock market investors, it is better to err on the side of caution and concentrate on the fundamentals of each stock rather than the economy as a whole.