Economics for Today 9th Edition by Irvin Tucker

Exercise 8

DOES A STOCK MARKET CRASH CAUSE RECESSION?
Applicable Concept: consumption and investment
The stock market soared during the "Roaring 20s." Lavish spending was in style as people enjoyed their new wealth. Then, on October 29, 1929, Black Tuesday, the stock market crashed. During the Great Depression, banks failed, businesses closed their doors, real GDP plummeted, and unemployment soared. Over the years, much debate has occurred over whether the 1929 stock market crash was merely a symptom or a major cause of the downturn. Evidence exists that the 1929 stock market crash only reflected an economic decline already in progress. For example, months before Black Tuesday, national production had already fallen.
The argument over the impact of a stock market crash on the economy was renewed in 2001. The National Association for Business Economics (NABE) was holding its annual meeting in the World Trade Center when disaster struck the building on September 11, 2001. "The chandeliers shook, we heard a concussive sound, and as we were herding out, we could see that one tower was burning," said Carl Tannenbaum, the chief economist of LaSalle Bank in Chicago, who was attending the meeting. 1. "Worldwide, Hope for Recovery Dims," Business Week , September 24, 2001, p. 42. Just the day before, a panel of NABE economists predicted slow growth for the economy, but no recession. That forecast became obsolete the moment the first plane hit. Analysts predicted a recession, and one reason was that they expected the stock market would dive as profit expectations fell. Indeed, as a result of the September terrorist attacks, the stock market suffered its worst one-week loss since the Great Depression. In the immediate aftermath, equities losses were estimated to be an extraordinary $1.2 trillion in value.
Prior to the September attacks, the Dow Jones Industrial Average had reached a high of about 11,500 in May, but it had already fallen almost 2,000 points to a low of 9,431 on September 10, 2001. During this period of time, the economy was plagued by the implosion of the dot-com companies and sharp declines in high-tech stocks. After the attacks, the stock market closed for the remainder of the week and reopened the following Monday, September 17, 2001, with the famous statue of the Wall Street Bull decorated with American flags and the National Guard patrolling the streets. The result of trading was a huge sell-off and another loss of 1,371 points during the week. Throughout the remainder of the year, the Dow Jones Industrial Average gradually rose toward its pre-September 11 levels, closing at 10,022 on December 31, 2001. Real GDP contracted at a 1.3 percent annual rate in the third quarter of 2001 and then rose in the final three months of 2001 by 1.7 percent, which was a surprisingly strong performance under the circumstances. The six-member panel at the National Bureau of Economic Research (NBER), which is considered the nation's arbiter of U.S. business cycles, declared in November 2001 that a recession had begun in March and ended eight months later in November of that year.
Stock market plunges are widely reported headline news. One result of these plunges is that many Americans feel poorer because of the threat to their life's savings. In only a few hours, spectacular paper losses reduce the wealth that people are counting on to pay for homes, automobiles, college tuition, or retirement. Although not all U.S. households own stock, everyone fears a steep downhill ride on the Wall Street roller coaster. If a stock market crash leads to a recession, it will cause layoffs and cuts in profit sharing and pension funds. Businesses fear that many families will postpone buying major consumer items in case they need their cash to tide them over the difficult economic times ahead. Reluctance of consumers to spend lowers aggregate demand, and, in turn, prices and profits fall. Falling sales and anxiety about a recession may lead many business executives to postpone modernization plans. Rather than buying new factories and equipment, businesses continue with used plants and machinery, which means lower private investment spending, employment, output, and income for the overall economy.
Immediately following the attack on the United States on September 11, 2001, the stock market plunged and many observers predicted a recession. Using the consumption and investment functions, explain their predictions.