South-Western College Publishing - Economics  
Greenspan at Risk
Subject Consumption and Aggregate Expenditure
Topic Aggregate Demand/Aggregate Supply
Key Words Monetary Policy, Inflation, Aggregate Consumption
News Story

A typical prescription for the stock market's continued ascent is for the economy to avoid inflation and recession. Federal Reserve Chairman Alan Greenspan has over the year touted the economic growth, coupled with low inflation that the "new economy" has experienced. This phenomenon is seemingly at odds with the belief that continued economic growth produces low unemployment which, in turn, leads to inflationary wage hikes. Greenspan has also repeatedly warned stockholders about irrational exuberance and questioned whether the stock market is overvalued. In a recent speech, Greenspan suggested that investors reevaluate the level of risk incurred in buying shares of stock. The stock market reacted to this speech by the Dow dropping 266 points, the largest single drop in the index this year. Decreases in the value of wealth have important consequences for aggregate consumption.

In a mid-October speech before a conference of bank regulators, Mr. Greenspan questioned whether investors were assessing financial risk appropriately. The equity-risk premium is the extra return that an investor would demand from owning stocks rather than cash or bonds. As the price of stocks surged during the 1990s, the equity-risk premium fell. Mr. Greenspan suggested that this fall may be the consequence of Americans becoming bigger risk takers. If the inflation in stock prices is a bubble, a burst would have serious consequences for the economy. However, Mr. Greenspan also noted that part of the fall in the equity-risk premium may be the result of improvements in information technology that reduces the uncertainty about economic conditions. This new technology has made the management of business more stable and predictable, and therefore less risky.

The Federal Reserve is clearly worried about the stock market and increased stock prices. Even a decline in the equity-risk premium can be a problem if it lures investors into taking more and more risk in their portfolios. The consequences to the economy of a burst in the stock market bubble can be substantial.

(Updated December 1, 1999)

Questions What is the relationship between wealth and consumption?
2. What would happen to real gross domestic product (GDP) and the price level if a substantial decline in the stock market occurred? Explain.
3. Stock markets react to practically every speech that Mr. Greenspan makes. In part, they are concerned about higher interest rates. In part, they fear increased regulation. Explain how an increase in interest rates would affect bond and stock prices.
Source Jacob M. Schlessinger, "Which Mask Will Greenspan Wear Next," The Wall Street Journal, November 1, 1999.

Return to the Aggregate Demand/Aggregate Supply Index

©1998  South-Western College Publishing.  All Rights Reserved   webmaster  |   DISCLAIMER