Question

Suppose there is a report that the unemployment rate unexpectedly increased in the previous month. To what extent will the expected central bank response to this news affect how stock prices will respond to this report of a higher than expected unemployment rate? Explain. (about 50-100 words)

Answer 1

When there is widespread unemployment in the economy, the central bank tries to reduce the interest rates and reserve requirements , in efforts to increase economic activity in the economy such as, investment, businesses , transactions etc. As a result of lower interest rates, more businesses and investment houses are encouraged to borrow funds at cheaper rates and invest them at high returns investment.

The marginal efficiency of capital (MEC) represents the expected rate of returns to per unit investment made. Investments have an indirect or inverse relationship with interest rates, as at higher interest rates means higher cost of borrowing and thus the quantity investment made is low.

So, when the lending or credit rates are reduced by the Central Bank, the cost of borrowing is lower making the marginal efficiency of capital higher ( More returns compared to costs).

So when the interest rates are low, it results in increased investment in stock market, as investors from the bond market move to the equity market, as the cost of borrowings are less and thus investors are in a position to take higher risks for expected higher returns. As a result of increased demand for stocks in the stock market, the stock prises rises.