Macroeconomic Effects of Stock Market Fluctuations

This work contributes to discussion of the effects of share price fluctuations on aggregate output, employment and the dynamic behaviour of an economy with capital market imperfections. Greenwald and Stiglitz (1993) show that firms' capital structure may strongly affect aggregate output and employment as a consequence of undiversifiable bankruptcy costs. This paper extends the original model by introducing an efficient stock market which evaluates equities on the basis of the firm's expected profit prospects and by assuming that part of the firm's equities can be used as collateral to debt. Due to stock market fluctuations, a firm faces the risk of being undervalued when it needs to finance new production. The analysis of the individual firm's behaviour allows us to conclude that, firstly, stock market fluctuations are positively related to production and employment decisions through the marginal bankruptcy costs and, secondly, changes in the value of equities arising from the stock market may have greater impact on output and employment compared with changes in profit prospects for firms unquoted on the stock market. The analysis of the aggregate behaviour of the economy establishes that stock market fluctuations are at the centre of the relationships between general price level, price expectations and aggregate income. In particular, it can be established that, firstly, average share price variations anticipate a likely future price surprise and, secondly, an efficient stock market anticipates the real effects on output (and employment) of aggregate price shocks before these occur. These results lead us to suspect that an uncontrolled stock market, even if it is perfectly efficient, might be a source of instability for the whole economic system.