The impact of financial development on economy

Introduction

Financial markets instruments and institutions provide opportunities for investors to

specialize in particular markets or services, diversify risks, or both.

Why are financial markets and institutions important?

Financial markets play a critical role in the accumulation of capital and the production of
goods and services. The price of credit and returns on investment provide signals to
producers and consumersfinancial market participants. Those signals help direct funds
to the consumers, businesses, governments, and investors that would like to borrow
money by connecting those who value the funds most highly to willing lenders.
A well-functioning financial sector is crucial for a healthy economy. The 2008/2009
financial crisis has shown how the failure of single components can spill over to the whole
sector and, in the end, cause huge damage to the world economy. It indicates the
importance of attempts to find diagnostic tools for identification of sources of economic
and financial instability.

Classifications of Financial Markets

1.
2.
1.
2.

1.

Debt Markets
Short-term (maturity < 1 year) Money Market
Long-term (maturity > 1 year) Capital Market
Equity Markets
Common stocks
Primary Market
New security issues sold to initial buyers
Secondary Market
Securities previously issued are bought and sold

Exchanges
Trades conducted in central locations (e.g., New York Stock Exchange,
Chicago Commodity)
2.
Over-the-Counter Markets
Dealers at different locations buy and sell

Stock Market and Macroeconomy

Share of stock is a private financial asset, like a corporate bond
Both are issued by corporations to raise funds, both offer future payments to their owners
but what is the main difference between these two?
When a firm issues new shares of stock- called public offerings sale of which generates
funds for the firm- newly issued shares can be sold to someone else.
But why the firm still concerned about the price of its previously issued share?
first, the firms owners-its stockholders-want high share prices because that is the price
they can sell at.second, previously issued shares are perfect substitute of new public
offerings ,therefore, the firm cannot expect to receive higher price for its new shares than
the going price on its old shared
what is the result then??
In 1983, only 19 percents of Americans owned share of stocks either directly or
through mutual funds(?) in 2003, almost 50% American owned stock
You own a share of stock implies you own part of the corporation-own a fraction
of the companys total stock
you are entitled to a particular percent of the firms after tax profit
However, firms do not pay all their after-tax profit to share holders- some is kept
as retained earnings for later use of the firm
The part of profit distributed to share holders is called dividends
Aside from dividends, usually more important reason to holding stocks is to enjoy
capital gains return someone gets when they sell a stock at a higher price than
they paid for it
Tracking the stock market
Financial market is so important that stocks and bonds are monitored on a
continuous basis
You can find out the value of a stock instantly just by checking with a broker or
logging onto a website

 Daily news paper or specialized financial publication such as Wall Street Journal
or Financial Times report daily information
In addition to that, there are many stock market indices
Explaining Stock PricesStep #1: Characterize The Market
Price of a share of stocklike any other is determined in a market
Well characterize the market for a companys shares as perfectly competitive
View stock market as a collection of individual, perfectly competitive
markets for particular corporations shares
Many buyers and sellers
Virtually free entry
Step #2: Find The Equilibrium
Like all prices in competitive markets, stock prices are determined by supply and
demand
However, in stock markets, supply and demand curves require careful
interpretations
Figure 1 presents a supply and demand diagram for shares of Fedex Corporation
On any given day, number of Fedex shares in existence is just the number that the
firm has issued previously
Just because 302 million shares of Fedex stock exist, that does not mean
that this is the number of shares that people will want to hold
People have different expectations about firms future profits
At any price other than $90 per share, number of shares people are
holding (on the supply curve) will differ from number they want to hold
(on the demand curve)
Only at equilibrium price of $90 people satisfied holding number of
shares they are actually holding
Stocks achieve their equilibrium prices almost instantly

Figure 1: The Market For Shares of

: Figure 1
Fedex Corporation
Price per Share

$120

90

60
D
million 302

Number of Shares

Step #3: What Happens When Things Change?

Supply curve for a corporations shares shifts rightward whenever there is a
public offering
The changes we observe in a stocks priceover a few minutes, a few
days, or a few yearsare virtually always caused by shifts in demand
curve
what causes these sudden changes in demand for a share of stock?
In almost all cases, it is one or more of the following three factors
Changes in expected future profits of firm
Any new information that increases expectations of firms future
profits will shift demand curves of affected stocks rightward
Including announcements of new scientific discoveries,
business developments, or changes in government policy
Macroeconomic Fluctuations

 Any news that suggests economy will enter an expansion, or that

an expansion will continue, will shift demand curves for most
stocks rightward
Changes in the interest rate
A rise (drop) in the interest rate in the economy will shift the
demand curves for most stocks to the left (right)
Even expectations of a future interest rate change can shift demand curves for stocks.
News that causes people to anticipate a rise in interest rate will shift
demand curves for stocks leftward
Similarly, news that suggests a future drop in the interest rate will
shift demand curves for stocks rightward

Figure 2a: Shifts in the Demand

for Shares Curve
(a)
Price
per Share

$75

The demand curve shifts rightward when

:new information causes expectations of
higher future profits
economic expansion
lower interest rates

60

D1
million 298

D2

Number of Shares

Figure 2b: Shifts in the Demand

for Shares Curve
(b)
Price
per Share

The demand curve shifts leftward when

:new information causes expectations of
lower future profits
recession
higher interest rates

60
45
D3

D1

Number of Shares

million 298

The Two-Way Relationship Between The Stock

Market and the Economy

Stock
Market

Macroeconom
y

How the Stock Market Affects the Economy

The Wealth Effect
To understand how market affects economy, lets run through following mental
experiment

 Suppose that, for some reason stock prices rise

When stock prices rise, so does household wealth
What do households do when their wealth increases?
Typically, they increase their spending
Link between stock prices and consumer spending is an important one, so
economists have given it a name
Wealth effect
Tells us that autonomous consumption spending tends to move in
same direction as stock prices
When stock prices rise (fall), autonomous consumption spending
rises (falls)

The Wealth Effect and Equilibrium GDP

Autonomous consumption is a component of total spending
Can summarize logic of the wealth effect

Changes in stock pricesthrough the wealth effectcause both equilibrium GDP and
price level to move in same direction
An increase in stock prices will raise equilibrium GDP and price level ,While a decrease
in stock prices will decrease both equilibrium GDP and price level
How important is wealth effect?
Economic research shows that marginal propensity to consume out of
wealth is between 0.03 and 0.05
Change in consumption spending for each one-dollar rise in
wealth
As a rule of thumb, a 100-point rise in DJIAwhich generally means a rise in
stock prices in generalcauses household wealth to rise by about $100 billion

 This rise in household wealth will increase autonomous consumption

spending by between $3 billion and $5 billionwell say $4 billion
Rapid increases in stock prices can cause significant positive demand shocks to
economy, shocks that policy makers cannot ignore
Similarly, rapid decreases in stock prices can cause significant negative
demand shocks to economy, which would be a major concern for policy
makers

Aggregate Expenditure

The Effect of Higher Stock Prices

on the Economy
(a)

(b)
AS

Price
Level

AEhigher stock prices

AElower stock prices
P2
P1

ADhigher stock prices

ADlower stock prices

45
Y1

Y2

Real GDP

Y1 Y3 Y2

Real GDP

Lets look at the other side of the two-way relationship

How economy affects stock prices
Many different types of changes in the overall economy can affect the stock
market
Lets start by looking at the typical expansion
Real GDP rises rapidly over several years
In typical expansion (recession), higher (lower) profits and stockholder optimism
(pessimism) cause stock prices to rise (fall)

What Happens When Things Change?

Figure 5 illustrates three different types of changes we might

explore

Three Types of Shocks

Shock to
stock
market

Stock Market

Shock to
macroeconom
y

Macroeconomy

Shock to both
stock market
and
macroeconomy
A change might have most of its initial impact on the
overall economy, rather than the stock market
There might be a shock that initially affects stock market
Shock could have powerful, initial impacts on both stock
market and overall economy
A Shock to the Economy
Imagine that new legislation greatly increases government
purchases

 To equip public schools with more sophisticated

telecommunications equipment, or to increase the
strength of our armed forces
What will happen?
Rise in government purchases will first increase real
GDP through expenditure multiplier
When we include effects of stock market, expenditure multiplier
is larger
An increase in spending that increases real GDP will also
cause stock prices to rise, causing still greater increases in
real GDP
Similarly, a decrease in spending that causes real GDP to
fall will also cause stock prices to fall, causing still greater
decreases in real GDP
This is one reason why stock prices are so carefully
watched by policy makers, and matter for everyone
Whether they own stocks themselves or not

A Shock To the Economy and the Stock Market: The High-Tech Boom
of the 1990s
1990sespecially second halfsaw dramatic rise in stock prices
Growth in real GDP averaged 4.2% annually from 19952000
In part, economic expansion and rise in stock prices were
reinforcing
Each contributed to the other
Internet had a direct impact on stock market through its effect
on expected future profits of U.S. firms
At the same time, technological revolution was having a huge
impact on overall economy
Faced with these demand shocks, Federal Reserve would
ordinarily have raised its interest rate target to prevent real GDP
from exceeding potential output
Technological changes of 1990s were an example of a shock to
both stock market and economy
Result was a market and an economy that were feeding on
each other, sending both to new performance heights
Was this a good thing?
Yes, and no
In spite of all this good news, there were dark clouds on horizon

THE IMPACT OF THE FINANCIAL MARKETS DEVELOMENT ON THE

JORDAN ECONOMY
The economic role of stock markets in relatively less developed countries is less clear.
Specifically, how do less developed markets respond to changes in their fundamental
economic variables, compared with the well-developed and more efficient markets?
Because the structure of the ASE differs from that of the developed countries,
ASE price movements may be different. This market may be more subject to
speculative activities, manipulations, and especially government interventions than
well-developed markets. Owing to different investor participations, it is possible that
the ASE respond to economic variables differently from markets in well-developed
countries.

The study of the Jordanian market is not purely statistical ,it is based on the market
variables differences between Jordan and the other countries , In this study, we access
to a collection of articles about the Jordanian economy in order to understand these
determinants that affect on the Jordanian economy .
Causal Relations among Stock Prices and Macroeconomic Variables in the
Small, Open Economy of Jordan : AKTHAM MAGHAYEREH
Assistant Professor .The Hashemite University, Zarqa, Jordan)
The investors perceptions of stock price movements in the ASE are highly sensitive
to the international environment especially to the economic and political
environments in the neighboring Arab countries.
Evaluating the Impact of Financial Development on Economic Growth in Jordan
(Idries Mohammed Al-Jarrah . Faculty of Business Administration :
The University of Jordan)
The main remark based on this analysis is that despite employing large number of
financial development indicators which proven to be high correlated with each other
and have witnessed significant growth over the study period, the impact of these
variables on economic growth is limited which necessitate further studies to detect
the main obstacles that deter the economic growth in Jordan
Stock markets ,Bank and economic growth (Jordan) (Eman F. Abu-Mhareb .
: The University of Jordan)
This study examines the causal relationship between stock market, banks and
economic growth in Jordan in order to establish whether financial development is
supply-leading or demand-following.
empirical results do not support the hypothesis that financial development lead to
changes in economic growth in Jordan. However, econometric analysis brings
evidence that the effect of the local macroeconomic variables (trade openness and
industrial production) on the economic growth is more important than that of financial
indicators.

References
JORDAN ECONOMIC MONITOR
Poverty Reduction and Economic Management Unit
MIDDLE EAST AND NORTH AFRICA REGION
The World Bank
Stock markets ,Bank and economic growth (Jordan) (Eman F. Abu-Mhareb .
: The University of Jordan)

Macroeconomics and Finance: The Role of the

Stock Market
Stanley Fischer, Robert C. Merton
NBER Working Paper No. 1291 (Also Reprint No. r0594)
Issued in April 1985

The Role of Macroeconomic Variables on Stock Market Index

Seyed Mehdi Hosseini
School of Management, University Sains Malaysia
International Journal of Economics and Finance

Relationship between Macroeconomic Variables

and Stock Market Indices
Jurnal Pengurusan 24(2004) 47-77
Ramin Cooper Maysami
Lee Chuin Howe
Mohamad Atkin Hamzah
Simple Keynesian Model
Causal Relations among Stock Prices and Macroeconomic Variables in the
Small, Open Economy of Jordan : AKTHAM MAGHAYEREH
Assistant Professor .The Hashemite University, Zarqa, Jordan)
Evaluating the Impact of Financial Development on Economic Growth in Jordan
(Idries Mohammed Al-Jarrah . Faculty of Business Administration :
The University of Jordan)