How Does the Stock Market Influence Our Economy?

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The stock market affects the U.S. economy in three important ways:

  • as the principal funding source for U.S. business.
  • as the most important means of investment for individual U.S investors.
  • as a critical barometer of the economy that also is an important means of economic regulation by the Federal Reserve.

Funding Capitalism

It's generally conceded that one important function of the stock market is to fund business. At some point of development, nearly every domestic business that attains or hopes to attain a certain scale seeks financing through the U. S. stock market. Investment bank market participants, such as Goldman Sachs, bring a company's stock shares to market by making an initial public offering, or IPO. of shares to investors.

Without this highly-regulated and closely observed process, companies would have no easy way of raising funds other than through private offerings and taking on debt, and individual investors would have no easy and safe way to invest. As Columbia University's Richard R. Nelson notes in "Capitalism is the Engine of Progress," not only is the stock market the primary driver of capital growth; as economies advance from an industrial to a technological stage, stock market funding of research and development takes on an increasingly critical role in driving the economy forward.

Individual Investor Benefits

The stock market offers an easily understood, relatively safe way for individual investors and other financial entities to participate in capital markets by buying and selling the shares of public companies. This is particularly important for individual investors seeking to fund their retirements. Although in the short term stock markets are cyclical and present moderate short-term risk, in the long term large stock markets like those in the United States present relatively safe low-risk means of investing over the long term. For over 100 years, the U.S. stock market has returned slightly more than 9 percent annually. This means that over a period 35 years of steady investing you can become a millionaire in retirement with a total investment of just a little over $200,000 thanks to compounded interest and market gains over time.

Economic Barometer and Regulator

The market has two more important functions that are somewhat interrelated. The stock market's cyclical rise and fall, although not in exact sync with the economy, provides economists, businesses and investors with a generally accurate understanding of the economy overall. In association with other indicators related to the market, the S&P 500 Index is a reliable barometer of economic health. When it falls significantly in a bear market, investors feel vulnerable and pull back in every aspect of their economic life -- they put off buying that new car, taking that vacation abroad, sending the kids off to private school and so forth. This response by investors reduces economic activity and further depresses the economy. The opposite holds true in a bull market, when investors feel optimistic and begin spending more. The same reflexiveness holds true in bull markets as well; as consumers spend more, they buoy the market further.

The interrelation of the stock market and overall economy, gives the Federal Reserve a convenient means of aiding the economy's maximum sustainable growth and employment. When the economy seems in danger of overheating -- a symptom usually accompanied sooner or later by inflation -- the Federal Reserve restricts the supply of money entering the economy. Similarly, when the economy is in danger of contraction, the Federal Reserve stimulates it by increasing the flow of money into the economy.

In both cases, an important avenue for this regulation is the stock market. When the Fed restricts the money supply, for example, this raises interest rates and reduces economic activity by making it more expensive for companies to innovate or expand with borrowed funds. This reduction in new economic activity effectively clamps down a rising stock market. When market growth slows down, this inhibits economic activity further.

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