What Is the Connection between the Stock Market and Economic Growth?

K. Kinsella

Economic growth occurs when production levels increase in response to consumer demand. The stock market and economic growth are inextricably linked because the stock market rises and falls in conjunction with the fortunes of the companies that drive economic expansion. While stock markets serve as useful barometers for people who are attempting to measure growth, some economists even argue that stock markets encourage growth.

The stock market reflects the changing status a company's performance and outlook.
The stock market reflects the changing status a company's performance and outlook.

Growth normally begins when companies respond to increased demand for goods and supplies by hiring new workers. In order to cover the cost of hiring new employees, companies rely on borrowed funds or investments of capital from the company owners. Many firms borrow money in the form of long-term debts called bonds and these instruments can be bought and sold on stock markets around the world. Additionally, ownership stakes or stocks in companies are also bought and sold on stock markets and firms raise money by selling batches of shares to investors. The use of marketable bonds and stocks to raise capital means that there is a direct connection between a nation's stock market and economic growth.

In the absence of stock markets, companies have to rely on company owners using their own savings to fund the company's expansion or on funds that are borrowed from financial institutions. Banks fund loans by borrowing money at low rates of interest from consumers, and then lending that money at a higher rate to business and consumer borrowers. Traditionally, banks have served as intermediaries in the transfer of funds from savers to borrowers such as expanding corporations. Advocates of the free market argue that stock markets eliminate banks as intermediaries and this means that funds can be passed more efficiently from savers to borrowers. Many economists believe that the relationship between the stock market and economic growth is one of mutually dependency since easy access to funds enables corporations to expand and that spurs growth.

Critics of free market economies also recognize the connection between the stock market and economic growth but argue that stock markets can actually negatively impact growth over the long term. These individuals believe that investors are less likely to make investments in long-term illiquid products such as Certificates of Deposit (CDs) if they have constant access to highly liquid growth instruments such as stocks. Since banks use CD money and funds from similar types of products to fund mortgages and long-term loans, these banks have to curtail such lending when large numbers of investors divert their money to stocks and other securities. In the opinion of some economists, this can make sustainable long-term growth harder to achieve.

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