We’ve learned that the financial system is an essential part of the economy; without stock markets, bond markets, and banks, long-run economic growth would be hard to achieve. Yet the news isn’t entirely good: the financial system sometimes doesn’t function well and instead is a source of instability in the short run. In fact, the financial consequences of a sharp fall in U.S. housing prices became a major problem for economic policy-makers starting in the summer of 2007. By the fall of 2008, it was clear that the U.S. economy was facing a severe slump as it adjusted to consequences of greatly reduced home values. Canada’s economy and those of the many other countries faced significant hardship as this adverse U.S. shock spread around the world. By the end of 2008, our economy experienced a recession owing to the drop in U.S. demand for Canadian exports and uncertainty in financial markets. And in 2012, the time of writing, the economy was only slowly recovering from a severe recession.

We could easily write a whole book on asset market fluctuations. In fact, many people have. Here, we briefly discuss the causes of asset price fluctuations.

Once a company issues shares of stock to investors, those shares can then be resold to other investors in the stock market. And these days, thanks to cable TV and the Internet, you can easily spend all day watching stock market fluctuations—the movement up and down of the prices of individual stocks as well as summary measures of stock prices like the S&P/TSX Composite Index and the Dow Jones Industrial Average. These fluctuations reflect changes in supply and demand by investors. But what causes the supply and demand for stocks to shift?

Remember that stocks are financial assets: they are shares in the ownership of a company. Unlike a good or service, whose value to its owner comes from its consumption, the value of an asset comes from its expected ability to generate higher future consumption of goods or services. A financial asset allows higher future consumption in two ways. First, many financial assets provide regular income to their owners in the form of interest payments or dividends. But many companies don’t pay dividends; instead, they retain their earnings to finance future investment spending. Investors purchase non-dividend-paying stocks in the belief that they will earn income from selling the stock in the future at a profit, the second way of generating higher future income. Even in the cases of a bond or a dividend-paying stock, investors will not want to purchase an asset that they believe will sell for less in the future than today because such an asset will reduce their wealth when they sell it.

So the value of a financial asset today depends on investors’ beliefs about the future value or price of the asset. If investors believe that it will be worth more in the future, they will demand more of the asset today at any given price; consequently, today’s equilibrium price of the asset will rise. Conversely, if investors believe the asset will be worth less in the future, they will demand less today at any given price; consequently, today’s equilibrium price of the asset will fall. Today’s stock prices will change according to changes in investors’ expectations about future stock prices.

Suppose an event occurs that leads to a rise in the expected future price of a company’s shares—say, for example, Bombardier announces that it forecasts higher than expected probability due to a new contract for light rail vehicles in Europe. Demand for Bombardier shares will increase. At the same time, existing shareholders will be less willing to supply their shares to the market at any given price, leading to a decrease in the supply of Bombardier shares. And as we know, an increase in demand or a decrease in supply (or both) leads to a rise in price. Alternatively, suppose that an event occurs that leads to a fall in the expected future price of a company’s shares—say, Air Canada announces that it expects lower profitability because a rise in fuel prices has depressed both profit margins and the demand for flights. Demand for Air Canada shares will decrease. At the same time, supply will increase because existing shareholders will be more willing to supply their Air Canada shares to the market. Both changes lead to a fall in the stock price.

So stock prices are determined by the supply and demand for shares—which, in turn, depend on investors’ expectations about the future stock price.

Stock prices are also affected by changes in the attractiveness of substitute assets, like bonds. As we learned early on, the demand for a particular good decreases when purchasing a substitute good becomes more attractive—say, due to a fall in its price. The same lesson holds true for stocks: when purchasing bonds becomes more attractive due to a rise in interest rates, stock prices will fall. And when purchasing bonds becomes less attractive due to a fall in interest rates, stock prices will rise.

Everything we’ve just said about stocks applies to other assets as well, including physical assets. Consider the demand for commercial real estate—office buildings, shopping malls, and other structures that provide space for business activities. An investor who buys an office building does so for two reasons. First, because space in the building can be rented out, the owner of the building receives income in the form of rents. Second, the investor may expect the building to rise in value, meaning that it can be sold at a higher price at some future date. As in the case of stocks, the demand for commercial real estate also depends on the attractiveness of substitute assets, especially bonds. When interest rates rise, the demand for commercial real estate decreases; when interest rates fall, the demand for commercial real estate increases.

Most Canadians don’t own commercial real estate. A large fraction of the population does not own any stock, not even indirectly through mutual funds, and for most of those people who do own stock, ownership is well under $50 000. However, at the end of 2011 about 70% of Canadian households owned another kind of asset: their own homes. What determines housing prices?

You might wonder whether home prices can be analyzed the same way we analyze stock prices or the price of commercial real estate. After all, stocks pay dividends, commercial real estate yields rents, but when a family lives in its own home, no money changes hands.

In economic terms, however, that doesn’t matter very much. To a large extent, the benefit of owning your own home is the fact that you don’t have to pay rent to someone else—or, to put it differently, it’s as if you were paying rent to yourself. In fact, the Canadian government includes “imputed rent”—an estimate of the amount that homeowners, in effect, pay to themselves—in its estimates of GDP.

The amount people are willing to pay for a house depends in part on the imputed rent they expect to receive from that house. The demand for housing, like the demand for other assets, also depends on what people expect to happen to future prices: they’re willing to pay more for a house if they believe they can sell it at a higher price sometime in the future. Last but not least, the demand for houses depends on interest rates: a rise in the interest rate increases the cost of a mortgage and leads to a decrease in housing demand; a fall in the interest rate reduces the cost of a mortgage and causes an increase in housing demand.

All asset prices, then, are determined by a similar set of factors. But we haven’tyet fully answered the question of what determines asset prices because we haven’t explained what determines investors’ expectations about future asset prices.

There are two principal competing views about how asset price expectations are determined. One view, which comes from traditional economic analysis, emphasizes the rational reasons why expectations should change. The other, widely held by market participants and also supported by some economists, emphasizes the irrationality of market participants.

The Efficient Markets Hypothesis Suppose you were trying to assess what Air Canada’s stock is really worth. To do this, you would look at the fundamentals, the underlying determinants of the company’s future profits. These would include factors like the changing vacation habits of the Canadian public and the prospect that competition from other air carriers and travel websites, such as Expedia.ca, could shrink profit margins. You would also want to compare the earnings you could expect to receive from Air Canada with the likely returns on other financial assets, such as bonds.

According to one view of asset prices, the value you would come up with after a careful study of this kind would, in fact, turn out to be the price at which Air Canada stock is already selling in the market. Why? Because all publicly available information about Air Canada’s fundamentals is already embodied in its stock price. Any difference between the market price and the value suggested by a careful analysis of the underlying fundamentals indicates a profit opportunity to smart investors, who then sell Air Canada stock if it looks overpriced and buy it if it looks underpriced. The efficient markets hypothesis is the general form of this view; it means that asset prices always embody all publicly available information. An implication of the efficient markets hypothesis is that at any point in time stock prices are fairly valued: they reflect all currently available information about fundamentals. So they are neither overpriced nor underpriced.

Another implication of the efficient markets hypothesis is that the prices of stocks and other assets should change only in response to new information about the underlying fundamentals. Since new information is by definition unpredictable—if it were predictable, it wouldn’t be new information—movements in asset prices are also unpredictable. As a result, the movement of, say, stock prices will follow a random walk—the general term for the movement over time of an unpredictable variable.

The efficient markets hypothesis plays an important role in understanding how financial markets work. Most investment professionals and many economists, however, regard it as an oversimplification. Investors, they claim, aren’t that rational.

Irrational Markets? Many people who actually trade in the markets, such as individual investors and professional money managers, are skeptical of the efficient markets hypothesis. They believe that markets often behave irrationally and that a smart investor can engage in successful “market timing”—buying stocks when they are underpriced and selling them when they are overpriced.

Although economists are generally skeptical about claims that there are surefire ways to outsmart the market, many have also challenged the efficient markets hypothesis. It’s important to understand, however, that finding particular examples where the market got it wrong does not disprove the efficient markets hypothesis. If the price of Air Canada stock plunges from $1.80 to $0.70 because of a sudden change in fuel prices and vacation habits, this doesn’t mean that the market was inefficient in originally pricing the stock at $1.80. The fact that vacation habits were about to change wasn’t publicly available information, so it wasn’t embodied in the earlier stock price.

Serious challenges to the efficient markets hypothesis focus instead either on evidence of systematic misbehaviour of market prices or on evidence that individual investors don’t behave in the way the theory suggests. For example, some economists believe they have found strong evidence that stock prices fluctuate more than can be explained by news about fundamentals. Others believe they have strong evidence that individual investors behave in systematically irrational ways. For example, people seem to expect that a stock that has risen in the past will keep on rising, even though the efficient markets hypothesis tells us there is no reason to expect this. The same appears to be true of other assets, especially housing: the great U.S. housing bubble arose in large part because homebuyers assumed that home prices would continue rising in the future.

How should macroeconomists and policy-makers deal with the fact that asset prices fluctuate a lot and that these fluctuations can have important economic effects? This question has become one of the major problems facing macroeconomic policy. On one side, policy-makers are reluctant to assume that the market is wrong—that asset prices are either too high or too low. In part, this reflects the efficient markets hypothesis, which says that any information that is publicly available is already accounted for in asset prices. More generally, it’s hard to make the general case that government officials are better judges of appropriate prices than private investors who are putting their own money on the line.

On the other side, the past 15 years were marked by not one but two huge asset bubbles, each of which created major macroeconomic problems when it burst. In the late 1990s the prices of technology stocks, including but not limited to dot-com Internet firms, soared to hard-to-justify heights. When the bubble burst, these stocks lost, on average, two-thirds of their value in a short time, helping to cause the 2001 recession and a period of high unemployment in the U.S. A few years later there was a major bubble in U.S. housing prices. The collapse of this bubble in 2008 triggered a severe worldwide financial crisis followed by a deep recession.

These events have led to a fierce debate among economists over whether policy-makers should try to pop asset bubbles before they get too big. We’ll describe that debate in Chapter 17.