Stocks represent ownership interest in companies and are important to individuals and businesses. Stocks are a key component of individual retirement portfolios. Businesses access the stock markets to raise capital for strategic and operational reasons. Stock prices influence consumer and business confidence, which affects the economy. The relationship also works the other way, in that economic conditions often affect stock markets.
Stock price movements have a psychological impact on individuals and businesses. Rising stock markets, or bull markets, can create a sense of confidence about the direction of the economy. As prices continue to rise, more investors come into the market, which builds on the momentum. Falling stock markets, or bear markets, usually have the opposite effect. People feel pessimistic about the economy. Media reports often create a sense of panic. People start moving funds away from stocks into low-risk assets, which can depress stock prices even further.
Bull markets can create a wealth effect. People feel more confident as their investment portfolios rise in value. They spend more on nonessential and big-ticket items, such as homes and cars. Conversely, falling stock prices create a reverse wealth effect. Falling portfolio values can create uncertainty about the future of the economy. People hold back on their spending, especially on nonessential items. This slows down economic growth because consumer spending is a key component of the gross domestic product.
Stock prices can affect business investments. Businesses are likely to make capital investments when they feel that these investments will lead to rising market values, such as during rising or bull markets. Management has more operational flexibility if sustained stock price increases lead to increased consumer spending. Merger and acquisition activity tends to increase during bull markets because companies can use stock as currency. Initial public offerings increase as new companies take advantage of market optimism to raise capital. Bear markets have the opposite effect. Businesses become less confident about investing in new infrastructure projects or expansion plans. Merger activity slows down, as does the number of new company listings. This reduction in business investment activity slows down the economy.
Stock markets are one of the factors that affect the economy, but there are others as well. Interest rates affect the economy because rising rates mean higher borrowing costs. Consumer spending and business investment slows down, which reduces economic growth. Falling interest rates can stimulate economic growth. Fiscal policy decisions also can affect the economy. For example, large budget deficits can reduce government investments and purchases, which can slow down the economy. Currency fluctuations can drive up the price of exports, which can harm export-driven economies.
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