Question

In the boom years of the late 1990s, it was often said that rapidly increasing stock prices were responsible for much of the rapid growth of real GDP. Explain how this could be true, using aggregate demand and aggregate supply analysis.

Short answer

Answer: The rapid increase in stock prices during the late 1990s led to increased household wealth, which in turn caused higher consumption and aggregate demand. This increased demand spurred businesses to produce more goods and services, resulting in the rapid growth of real GDP.

Step-by-step solution

The relationship between stock prices and household wealth

Stock prices reflect the value of shares in publicly traded companies. When stock prices rise, the value of these shares and, in turn, the wealth of households holding these stocks, also increases. In general, a rise in stock prices leads to an increase in household wealth.

The impact of household wealth on consumption and aggregate demand

An increase in household wealth can lead to an increase in consumption, as people feel wealthier and are more confident about their financial future. This increase in consumption is known as the wealth effect. When households consume more goods and services, aggregate demand in the economy rises as well. Aggregate demand is the total demand for goods and services at different price levels and is represented by the equation: AD = C + I + G + (X-M), where C is consumer spending, I is investment, G is government spending, and (X-M) is net exports.

The effect of aggregate demand on real GDP

Real GDP is a measure of the market value of all goods and services produced within a country during a specific period of time, adjusted for inflation. When aggregate demand increases due to the wealth effect from rising stock prices, businesses tend to produce more goods and services to meet the increase in demand. As a result, real GDP also increases.

The role of aggregate supply in determining real GDP

Aggregate supply is the total supply of goods and services produced within an economy at different price levels. The interaction between aggregate demand and aggregate supply determines the equilibrium price level and real GDP. In the short run, when aggregate demand increases, firms may not be able to increase their production (due to input constraints) but will instead raise their prices. However, in the long run, firms are generally able to respond to higher demand by increasing their production capacity, leading to a rise in real GDP. In conclusion, the rapid increase in stock prices during the late 1990s led to increased household wealth, which in turn caused higher consumption and aggregate demand. This increased demand spurred businesses to produce more goods and services, resulting in the rapid growth of real GDP.