Saving and Borrowing

This week: New Macroeconomics section! Get started with a video that asks -- what caused the Great Recession?

Next week: A closer look at one type of financial intermediary: banks.

On September 15, 2008, Lehman Brothers filed for bankruptcy, and signaled the start of the Great Recession. One key cause of that recession was a failure of financial intermediaries, or, the institutions that link different kinds of savers to borrowers.

We’ll get to intermediaries in the next video, but for now, we’ll first look at the market intermediaries are involved in.

This market is the combination of savers and borrowers—what we call the “market for loanable funds.”

To start, we’ll represent the market, using two curves you know well—supply and demand. The quantity supplied in the market comes from savings, and the quantity demanded comes from loans. But as you know, we have to factor in price. In the case of the market for loanable funds, the price is the current interest rate.

What happens to the supply of savings when the interest rate goes up? When are borrowers compelled to borrow more? Or less? We’ll cover these scenarios in this video.

One quick note: there’s not really one unified market for loanable funds. Instead, there are many small markets, with different sorts of lenders, lending to different sorts of borrowers. As we said in the beginning, it’s financial intermediaries, like banks, bond markets, and stock markets, which link these different sides of the market.

We’ll get a better understanding of these intermediaries in our next video, so stay tuned!

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[Alex] On September 15, 2008,

the world's financial system
was shaken to its core

when the investment bank,
Lehman Brothers,

filed for bankruptcy.

The impact was great, not simply
because Lehman was big,

but also because it was
an important financial intermediary,

an institution that
helps bridge the gap

between savers and borrowers.

The failure of Lehman marked
the beginning of a series of events

that signaled
the worst economic downturn

since the Great Depression.

And while there's several
significant angles

to the Great Recession,

one of them was
the decreased efficacy

of financial intermediation.

Now, some later videos
are going to go through this

in more detail.

But for now, we want to start
with some basic observations

as to why financial intermediation
is so important.

We'll start
with the supply of savings

and the demand to borrow,

and the market
which brings them together --

the Market for Loanable Funds.

And then we'll work our way up

to an examination
of The Great Recession.

So why do people borrow
and save at all?

Well, let's imagine a world
without borrowing and saving.

Most people's incomes
don't stay flat their entire lives.

They change in predictable ways.

Here's a typical pattern,

showing a person's income
over their life,

with their income
on the vertical axis

and time on the horizontal axis.

When you're young
and still in school,

you might make
a little bit of money,

waiting tables
or occasionally mowing lawns.

Your first job out of school --
it's going to pay more,

and after a few years
of experience

and hopefully
a few raises along the way,

you make more than you ever have.

Then, as you age,
you look forward to retirement,

when your income falls.

But you're no longer working,

and you could really enjoy
your golden years.

[Estelle from “Seinfeld” TV series]
“We're moving to Florida!”

[George] “What?
You're moving to Florida?

Ah-hah! That's wonderful!
I'm so happy!

For you! I'm so happy for you!”

[Alex] Now, let's imagine

if your consumption followed
the same path as your income

and you never saved or borrowed.

You'd struggle when young,

and you'd be unable
to invest in an education.

Then, you'd spend
every cent you make

during your prime working years.

Well, that sounds
like a lot of fun.

But without savings,
your income will drop suddenly

when you retire,
and so will your consumption.

Your golden years
wouldn't be so golden.

[Doug from “King of Queens” TV series]
If you're so smart,

why don't you tell them that
you live in my basement?

[Arthur] Why don't you tell them
you're enormous?

[Doug] Why don't you tell them that
your total salary last year was $12?

[Arthur] That was after taxes.

[Alex] So instead,
people tend to follow

a life-cycle theory of savings.

A person can start out consuming
more than she makes,

borrowing to fill that gap --

and to pay for things
like an education.

Then, during
her prime working years,

she makes more than she consumes,
paying down her debt

and saving the extra income
for retirement.

And when retirement comes,
she can spend those savings

and enjoy the golden years
even without working.

Now of course, many people
deviate from this exact path,

depending on details.

Most people, for example --
they consume less in college

than they do as professionals.

Ramen noodles are no longer
a staple of my diet.

But generally speaking,
many people follow a pattern

of borrowing, saving,
and dissaving

to smooth their consumption path
over their lifetime.

Of course, just like some people
can't wait until after dinner

to reach for that cookie jar,

not everyone saves and spends
in the same way.

How much you save and borrow
depends upon your time preference.

Some people -- they're more
impatient than others.

We all know someone
who spends everything they've got

and doesn't save enough.

On the other hand,
if you're keeping to a budget

and not spending too much
so that you can go to college,

well, that's an example
of being patient

and waiting
for higher consumption later.

We've also learned
from behavioral economics

that saving is not just a matter
of weighing costs and benefits.

Nudges can matter.

If your employer automatically
enrolls you in a retirement plan,

or sets a high
default contribution rate,

you'll probably end up saving more

than if you have to choose yourself,

even if choosing yourself
would only take a few hours of work

once in your lifetime.

Another important reason to borrow
is to make big investments.

Just as students borrow
to invest in education,

businesses borrow
to invest in big projects.

Entrepreneurs with great ideas
but not much money,

they may have to borrow
or sell a stake in their idea

just to get their venture
off the ground.

For example, Howard Schultz
built Starbucks into a global brand

by borrowing and raising capital

through several different types
of financial intermediaries.

We'll talk more about that
in upcoming videos.

As with any other good,

we're going to use
supply and demand

to analyze the market
for saving and borrowing,

known as the Market
for Loanable Funds.

As we've seen, there are
lots of good reasons

to save and to borrow.

But we have failed to mention
one big factor -- price.

What's the price
of saving and borrowing?

It's the interest rate.

So here's the supply curve
showing the supply of savings.

As the interest rate goes up,

the quantity
of savings supplied increases.

And here's the demand curve
showing the demand to borrow.

Lower interest rates
incentivize borrowing,

so as the interest rate falls,

the quantity
of borrowing demanded increases.

As with any other
supply and demand graph,

different factors
will shift the curves.

If a lot of people decide
that it'd be a good idea

to increase their savings,
for example,

then the supply of savings
will shift outward.

As you can see, this would
cause interest rates to fall.

This is what we saw in countries
like South Korea and China

as their populations saved more.

On the demand side,
if investors, say,

became less optimistic
for some reason,

the demand to borrow
would shift inward,

causing the interest rate to fall.

But, if, say an investment tax credit
from the government

increased the demand to invest,

then the demand curve will shift
in the opposite direction,

up and to the right,
pushing interest rates up.

Thinking about the Market
for Loanable Funds helps us

to see the big picture
and understand the raw factors

that determine interest rates

and the quantity
of borrowing and lending.

But there isn't actually
one market

called the Market
for Loanable Funds.

It's not like the New York
Stock Exchange.

Instead, there are many,
many, many markets

for different kinds of borrowers
and different kinds of lenders.

And there are different types
of institutions, like banks,

bond markets, and stock markets

that connect
the two sides of the market.

We're going to delve more deeply

into the different kinds
of financial intermediaries,

and why they're so important, next.

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to test yourself,

click "Practice Questions."

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