THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 172

CHAPTER 7

The Stock Market, the Theory of
Rational Expectations, and the
Efficient Market Hypothesis
LE A RNI NG OB J ECTI VES
After studying this chapter you should be able to
1. illustrate how stocks are valued as the present value of dividends
2. determine how information in the market affects asset prices: the theory of efficient capital markets, according to which current asset prices fully reflect all
available information

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Rarely does a day go by that the stock market isn t a major news item. We have
witnessed huge swings in the stock market in recent years. The 1990s were an
extraordinary decade for stocks: the S&P/TSX Composite in Canada and the Dow
Jones and S&P 500 indexes in the United States increased more than 400%, while
the tech-laden NASDAQ index rose more than 1000%. By May 2002, these indexes
had reached record highs. Unfortunately, the good times did not last, and many
investors lost their shirts in the recent spectacular decline of the stock market.
Because so many people invest in the stock market and the price of stocks
affects the ability of people to retire comfortably, the market for stocks is undoubtedly the financial market that receives the most attention and scrutiny. In this chapter, we look first at how this important market works.
We begin by discussing the fundamental theories that underlie the valuation of
stocks. These theories are critical to understanding the forces that cause the value
of stocks to rise and fall minute by minute and day by day. Once we have learned
the methods for stock valuation, we need to explore how expectations about the
market affect its behaviour. We do so by examining the theory of rational expectations, which has more general implications for how markets in other securities
besides stocks operate. When this theory is applied to financial markets, the
outcome is the efficient market hypothesis. The theory of rational expectations is

also central to debates about the conduct of monetary policy, to be discussed
in Chapter 27.