How can Finance influence economic activity?

Question

I'm not sure how to put it. I'm currently reading Blanchard's Macroeconomics. In a chapter, he explains how for example an unexpected shift in monetary policy, or in consumption or in fiscal policy, can affect the stock values, and the yield curves of bonds, but not how for example a financial bubble (stock/bond overpricing) can affect the economic activity of consumption, investment, etc. The perspective presented in the book seems a bit too one-way. I'm interested also in the other direction, from finance to economic activity.

Is there any bibliography that presents, in a academic way, this other perspective of finance affecting the economy?

Answer 1

This question, as mentioned, in incredibly broad. So, of course, this answer will not be complete. Also, I am unsure what you mean by "financial". I will try to answer this question, assuming that by "financial" you mean, specifically 'stock/bond' market.

Here is one link from NBER which should help you get started, kinda, since it only scrapes the surface.

There are two sections to consider:

Theoretical: As far as traditional, not necessarily classical, economic theory is concerned, stock and bond markets are corollaries and ancillaries of several factors of economic activity, e.g. capital market, money market, investment, employment etc.. That is, the financial market should just be an indication and investing mechanism based on real economic factors.

and,

Practical, Modern: Now, since so many different corporations and businesses invest and are invested in the stock/financial markets, volatility in the stock/financial market will affect them directly, or indirectly.

Directly: If these companies invest and are invested in, their valuation and/or income will be affect by market swings. For example, many of the financial firms which went under in the crisis.

Indirectly: The shifts in the market can affect the global position of investing. Attitude is perhaps the largest impact felt from the shifts in financial markets. If the general attitude on investing shifts, it makes it harder for new companies to gain investors, i.e. capital.

Answer 2

Short version:
Economic decisions (investment, consumer spending) are based on expectations. The financial market is considered to be a good indicator of some future processes. When stock prices fall it represents a change in expectations which results in a change in economic decisions.

Longer version:
A key factor in the stock price of a company is the expected cashflow of said company. I would argue that if the stock prices fall then the expectation about the economic environment is that businesses will make less money than previously expected. This makes investment less profitable than before hence it will be reduced. (Note that it is here that we pass from finance to so called 'real' factors, things that are measured in physical goods.)

Labor complements capital. The higher the capital the more productive labor is, and the more workers can be profitably employed. Because capital levels will not be rising as before, firms will not be hiring as much as before. In case of a significant stock price drop firms may even let people go. You can explain this with liquidity concerns, decrease in capital due to amortization, and a dozen other ways.

Because of reduced (or reduced comparatively to prior expectations) employment people will have less income and will probably consume less. This can even result in a feedback loop that further decreases firms' profits.