“Irrational exuberance:” That was how Federal Reserve Chairman Alan Greenspan once described the
booming stock market of the late 1990s. He was right that the market was exuberant: Average stock prices increased about fourfold during this decade. And perhaps it was even irrational: In the first few years of the following decade, the stock market took back some of these large gains, as stock prices experienced a pronounced decline, falling by about 40 percent from 2000 to 2003. Regardless of how we view the booming market, it does raise an important question: How should the Fed respond to stock-market fluctuations? The Fed has no reason to care about stock prices in them selves, but It docs ha ve the job of monitoring and responding to developments in the overall economy, and the stock market is a piece of that puzzle. When the stock market booms, households become wealthier, and this increased wealth stimulates consumer spending. In addition, a rise in stock prices makes it more attractive for firms to sell new shares of stock, and this stimulates investment spending. For.both reasons, a booming stock market expands the aggregate demand for goods and services. As we discuss more fully later in the chapter, one of the Fed’s goals is to stabilize aggregate demand, for greater stability in aggregate demand means greater stability in output and the price level. To do this, the Fed might respond to a stock-market boom by keeping the money supply lower and interest rates higher than it otherwise would. The ‘contractionary effects of higher interest rates would offset the expansionary effects of higher stock prices. In fact, this analysis does describe Fed behavior: Real interest rates were kept high by historical standards during the “irrationally exuberant” stock-market boom of the late I990s  The opposite occurs when the stock. market falls. Spending on consumption and investment declines, depressing aggregate demand and pushing the economy toward recession. To stabilize aggregate demand, the Fed needs to increase the money supply and lower interest rates. And indeed, that is what it typically does. For example, on October 19, 1987, the stock market fell by 22.6 percent-its biggest one-day drop in history. The Fed responded to the market crash by increasing the money supply and lowering interest rates. The federal funds rate fell from 7.7 percent at the beginning of October to 6.6 percent at the end of the month. In part because of the Fed’s quick action, the economy avoided a recession. Similarly, as we discussed in ~ case study in the preceding chapter, the Fed also reduced interest rates during the stock market declines of 2001 and 2002, although this time monetary policy was not ‘quick enough to’ avert a recession. While the Fed keeps an eye on the stock market, stock-market participants also keep an eye on the Fed. Because the Fed can influence interest rates and economic activity, it can alter the value of stocks, For example, when the Fed raises interest rates by reducing the money supply, it makes owning stocks Jess attractive for two reasons. First, a higher interest rate means that bonds, the alternative to stocks, are earning a higher return. Second, the Fed’s tightening of monetary policy reduces the demand for goods and services, which reduces profits. As a result, stock prices often fall when the Fed raises interest rates.