This Commentary makes a case for Fed action in the event of a stock market bubble. Because stock market prices serve as a signal to business managers to invest, bubbles can mislead managers into investing when it is not profitable. The overinvestment, which becomes apparent after the bubble bursts, can lead to a period of low investment, which can cause a recession. Policymakers may wish to step in to end a bubble before stock prices get too far out of line relative to their fundamentals.Stock market ; Stock - Prices

Paul Gomme

English

Research Papers in Economics

times GDP to 1 times GDP. Such a fall
in market wealth is estimated to have
caused a reduction in consumption of
0.36 percent of GDP. (This figure is cal-
culated using a reasonable estimate of
the degree to which U.S. consumers
change their consumption when their
wealth changes—known as the “mar-
ginal propensity to consume out of
wealth”—of 4 percent. That is, for every
$100 decline in wealth, the estimate sug-
gests that U.S. consumers lower their
consumption by $4.) Put differently, we
would expect GDP growth to be 0.36
percentage points lower than it would
have been had the stock market capital-
ization stayed at 1.9 times GDP. 
While 0.36 percentage points of growth
over 10 quarters is nothing to sneeze at, 
it certainly is not a disaster. In fact, it
would be difficult to identify a 0.36 per-
centage point change in growth in light
of the large and routine fluctuations in
GDP growth during a business cycle
expansion. In other words, this wealth
May 15, 2005
Federal Reserve Bank of Cleveland
Why Policymakers Might Care about 
Stock Market Bubbles 
by Paul Gomme
ISSN 0428-1276
This Commentary makes a case for
Fed action in the event of a stock 
market bubble. Because stock market
prices serve as a signal to business
managers to invest, bubbles can mis-
lead managers into investing when it
is not profitable. The overinvestment,
which becomes apparent after the
bubble bursts, can lead to a period of
low investment, which can cause a
recession. Policymakers may wish to
step in to end a bubble before stock
prices get too far out of line relative 
to their fundamentals.
On the face of it, it’s somewhat 
perplexing that variations in the stock
market should have effects on the macro-
economy more generally. After all, on
each side of a stock market transaction is
a buyer and a seller; the sale of stock by
one individual corresponds to the trans-
fer of ownership of a small piece of a
firm to another individual. Following
such a transaction, the firm can continue
to produce the same goods and services
since all the employees still work for the
firm, the firm still owns the same plant
and equipment, and the particular ways
of utilizing these inputs are still known. 
But the stock market’s ups and downs
can have very real, if not direct, effects
on the macroeconomy. Stock market
bubbles are a case in point. The
inevitable crash that follows a bubble
has the potential to cause recessions—
the Great Depression being the worst-
case example of that connection to date.
The mere possibility of repeating an
episode so destructive warrants policy-
makers’interest in the behavior of the
stock market, even though the link
between the stock market and the
macroeconomy may not be well under-
stood. Indeed, there is continuing
debate within the economics profession
over the exact causes of the Great
Depression, as well as the factors that
led to its severity and duration. We
should also keep in mind that the link
between the stock market and the
macroeconomy is not very tight. As
Paul Samuelson quipped, the stock mar-
ket has predicted nine of the last five
recessions. Perhaps the lack of a tight
connection between the stock market
and the macroeconomy is a positive
development, particularly if we think
that policymakers have managed to
insulate the macroeconomy somewhat
from stock market fluctuations.
If there isn’t much of a link between the
stock market and the supply side of the
economy (the ability of the economy to
produce goods and services), then per-
haps there is one between the stock mar-
ket and the demand side (the influences
on demand for goods and services). Two
likely candidates present themselves:
consumption and investment. The next
section briefly examines the consump-
tion channel and finds that it simply isn’t
big enough. We then examine the more
promising channel of investment. We
consider a particular theory of invest-
ment (known to economists as Tobin’s
q), but the crux of the argument is that
stock market prices serve as a signal to
firms’managers to buy new investment
goods. We will see that a stock market
crash can very quickly lead to a reduc-
tion in investment, and so a recession.
Further, we will see that such invest-
ment-triggered recessions may be 
long-lived. 
■ Wealth Effects
One reason that fluctuations in stock
prices may affect the macroeconomy is
that individuals who hold stocks, either
directly or indirectly (for example,
through mutual funds or pension plans),
feel poorer when the stock market falls.
This wealth effect causes people to cut
back on their consumption, a major
component of aggregate demand. 
How big might these wealth effects be?
Consider what happened during the
stock market decline that began in the
first quarter of 2000 and ended in the
third quarter of 2002. Over this period,
the combined market capitalization of
the NASDAQ and NYSE fell from 1.9effect is unlikely the channel that
causes stock market crashes to lead 
to recessions. 
■ Tobin’s q
We now turn to a more promising 
channel between the stock market and
the macroeconomy: investment. Some
economists argue that stock market
prices provide information that business
managers use to make investment deci-
sions, and when the market is 
overvalued, it leads to overinvestment.
James Tobin expressed this idea in 
his “q theory” of investment. It’s only
one way the stock market might affect
investment and, in turn, the macro-
economy, but it will serve to illustrate
how the link might work.  
To start, Tobin defines a “marginal q”
for a firm as the ratio of the market
value of new additional investment
goods to their replacement cost. The
reason q is of interest is that only when
q is greater than one should the firm
invest (purchase new capital goods). To
understand why q being greater than
one is the crucial relationship, consider
the following example. Suppose that a
firm has an investment project that costs
$1 million to implement, and this pro-
ject will increase the market value of 
the firm by $1.5 million. In this case, q
equals 1.5, and proceeding with the pro-
ject generates a net gain of $500,000. 
In fact, only when q is greater than one
will a project generate a net gain for 
the firm. 
While the replacement cost of new 
capital goods is known, figuring out
how the stock market will value the
firm with this new investment is prob-
lematic. Consequently, the related
“average q” is more typically used; it is
defined as the ratio of the stock market
valuation of the firm to the replacement
cost of its assets. Notice that if average
q is greater than 1, then investors’valu-
ation of the firm exceeds the cost of its
assets. Again, average q being greater
than one is the key relationship that 
signals what we would expect to 
happen to investment in the future.
Consider a specific example: Suppose
the firm has a market value of $300
million, while the replacement cost 
of its assets is $250 million; then its
average q equals 1.2. Now, suppose that
the firm could create an exact replica 
of itself, at a cost of $250 million (the
replacement cost of its assets). If this
“copy” could be sold on the stock mar-
ket for $300 million (the current market
value of the firm), then $50 million in
additional value would be generated. In
other words, by spending only $250 mil-
lion, the replicated firm would have a
market value of $300 million, so that the
investment would yield a substantial
return and so should be undertaken. 
■ The Connection to the
Macroeconomy
The story told by Tobin’s q is, perhaps,
overly stylized. For example, it may be
difficult for firms to replicate them-
selves. The market value of a firm
includes the value of its intangible
assets—things like patents, copyrights,
and trademarks. In this case, we would
expect to see average q be greater than
one even though there is no compelling
reason for the firm to increase its invest-
ment activity. This example points out
that what we would really like to know 
is marginal q, but what we observe is
average q. 
Nonetheless, the basic intuition underly-
ing Tobin’s q is compelling: Changes in
stock prices should serve as a signal to
firms’managers. Consider what should
happen when a firm discovers a process
that makes it more productive, or equiva-
lently, allows it to produce its goods at a
lower cost than its competitors. Realiz-
ing the competitive advantage now held
by this firm, investors on the stock mar-
ket will bid up the price of the firm. This
run-up in the firm’s stock price then
serves as a signal to the firm’s managers
to increase their purchases of capital
goods. Through the lens of Tobin’s q the-
ory, the firm’s q would initially equal
one. Following the discovery of the new
process, the firm’s q would rise above
one as its stock price increases. Above,
we saw that when q is greater than one, it
is a signal to the firm to increase its pur-
chases of investment goods. 
Of course, the stock market prices of
other firms in the industry should fall
because they are now at a competitive dis-
advantage, and their qs will presumably
be driven below one. The fall in these
other firms’stock prices (such that their q
is less than one) signals that these firms
should not be buying investment goods. 
So, in the normal course of events, stock
market prices (firms’qs) send the appro-
priate signals to firms: Invest only if q is
greater than one. 
■ Stock Market Bubbles and
Investment
A problem arises when “irrational exu-
berance” leads to a “bubble” in stock
market prices—that is, when the stock
market prices of firms rise above their
fundamental prices, as dictated by the
present value of firms’current and
future dividends. In this case, many—
perhaps even all—firms see their q rise
above one. And according to q theory,
firm managers will increase their invest-
ment in capital goods. This is the first
problem: Owing to the stock price bub-
ble, firms are buying capital goods when
they “shouldn’t be.” 
The second problem arises when the
bubble pops. If firms’profitability is
more or less unchanged, then stock
prices should return to their previous
fundamental levels. But during the bull
market, firms acquired lots of capital
goods (after all, their qs were larger than
one). As a result, the replacement cost of
firms’assets has increased, thereby dri-
ving down their average qs. Conse-
quently, we would expect that firms
would curtail their purchases of invest-
ment goods for some time. 
Of course, there’s a complication in 
that firms have more capital goods at
their disposal and so can produce more
goods. Each firm now generates more
profits, and so the fundamental stock
market price of the firm should be
higher. But these investment projects
have relatively low returns; if they 
didn’t, firms would have made these
investments before the stock market
bubble. So while each firm can generate
more profits, now and in the future, the
increase in profits is smaller in percent-
age terms than the increase in the firm’s
assets. Consequently, the contribution 
of these additional capital goods still
constitutes a drag on average q. Firms’
purchases of investment goods will,
then, be low. 
■ Does It Matter?
Are policymakers right to be concerned
about the stock market? More impor-
tantly, if the stock market is character-
ized by a bubble, should policymakers
react? While a bursting bubble will cer-
tainly affect investment, if the investment
effects are small, then there is little for
policymakers to worry about—at least
from the macroeconomic perspective. The forces that perpetuate a stock mar-
ket bubble are somewhat better under-
stood than the causes of a bubble. Even
those investors who recognize that the
market is experiencing a bubble will
rationally participate in the bubble.
After all, stock market prices are rising,
and positive gains can be earned while
the bubble lasts—that is, so long as
there is some other investor willing to
buy your stock at an “inflated” price. It
is in this context that policymakers may
wish to step in to end the bubble before
stock prices get too far out of line rela-
tive to their fundamentals.
To estimate the size of the effects, con-
sider the following. From 1929 to the
present, private fixed nonresidential
investment (the relevant measure for the
q calculations) has averaged 9.5 percent
of GDP; if we consider only the
post–World War II period, the average
rises to 10.5 percent. So, following the
bursting of a stock market bubble, sup-
pose that investment falls from 10 per-
cent to 0 percent (the lower bound for
investment). Such a fall would precipi-
tate a 10 percent fall in GDP, and so a
10 percentage point fall in GDP growth.
Now we’re talking about recession-
sized changes in output. 
Such a fall in investment—and so
GDP—could easily occur very quickly.
Tobin’s q theory would suggest that the
fall would occur the instant that firms’
qs fall below one, but given the fact
that many investment projects take sev-
eral quarters to complete, the fall in
investment would likely be somewhat
more gradual. 
The period of low investment following
a stock market crash is likely to be 
prolonged. After all, during the bull
market preceding the crash, firms were
acquiring lots of capital goods. After the
crash, firms find themselves with more
capital than they “need”—a situation
often referred to as “capital overhang.”
Over time, this “excess” capital will 
be worked off through both economic
growth and depreciation of firms’exist-
ing capital. But this process can be
expected to take quite some time. 
■ Conclusions
This Commentary has given a potential
rationale for policymakers to monitor
the stock market. However, it is only
when there is a bubble—when stock
prices deviate from their fundamental
values—that trouble can arise. During a
bubble, firms are undertaking invest-
ments that they “shouldn’t.” When the
bubble pops and stock market prices
return to their fundamental prices, we
can expect a long period of low invest-
ment, and likely recession.Federal Reserve Bank of Cleveland
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