1 00:00:00,555 --> 00:00:03,555 ♪ [music] ♪ 2 00:00:14,300 --> 00:00:19,440 - [Alex] On September 15, 2008, the world's financial system was shaken to its 3 00:00:19,440 --> 00:00:24,780 core when the investment bank, Lehman Brothers, filed for bankruptcy. The impact 4 00:00:24,780 --> 00:00:30,080 was great not simply because Lehman was big, but also because it was an important 5 00:00:30,080 --> 00:00:36,240 financial intermediary, an institution that helps bridge the gap between savers 6 00:00:36,240 --> 00:00:41,700 and borrowers. The failure of Lehman marked the beginning of a series of events 7 00:00:41,700 --> 00:00:46,970 that signaled the worst economic downturn since the Great Depression. And while there's 8 00:00:46,970 --> 00:00:52,060 several significant angles to the Great Recession, one of them was the decreased 9 00:00:52,060 --> 00:00:55,290 efficacy of financial intermediation. 10 00:00:55,290 --> 00:00:59,840 Now, some later videos are going to go through this in more detail. But for now, 11 00:00:59,840 --> 00:01:03,840 we want to start with some basic observations as to why financial 12 00:01:03,840 --> 00:01:08,620 intermediation is so important. We'll start with the supply of savings and the 13 00:01:08,620 --> 00:01:12,980 demand to borrow, and the market which brings them together, the Market for 14 00:01:20,770 --> 00:01:26,430 So why do people borrow and save at all? Well, let's imagine a world without 15 00:01:26,430 --> 00:01:31,580 borrowing and saving. Most people's incomes don't stay flat their entire 16 00:01:31,580 --> 00:01:37,610 lives. They change in predictable ways. Here's a typical pattern, showing a 17 00:01:37,610 --> 00:01:42,220 person's income over their life, with their income on the vertical axis and time 18 00:01:42,220 --> 00:01:46,820 on the horizontal axis. When you're young and still in school, you might make a 19 00:01:46,820 --> 00:01:52,440 little bit of money, waiting tables or occasionally mowing lawns. Your first job 20 00:01:52,440 --> 00:01:56,250 out of school, it's going to pay more, and after a few years of experience and 21 00:01:56,250 --> 00:02:01,170 hopefully a few raises along the way, you make more than you ever have. Then, as you 22 00:02:01,170 --> 00:02:05,630 age, you look forward to retirement, when your income falls. But you're no longer 23 00:02:05,630 --> 00:02:10,500 working and you could really enjoy your golden years. 24 00:02:10,500 --> 00:02:13,090 - [Estelle from “Seinfeld” TV series] “We're moving to Florida!” 25 00:02:13,090 --> 00:02:19,390 - [George] “What? You're moving to Florida? Ah-hah! That's wonderful! I'm so happy! 26 00:02:19,390 --> 00:02:23,370 For you! I'm so happy for you!” 27 00:02:23,370 --> 00:02:29,720 - [Alex] Now, let's imagine if your consumption followed the same path as your income and 28 00:02:29,720 --> 00:02:35,140 you never saved or borrowed. You'd struggle when young, and you'd be unable 29 00:02:35,140 --> 00:02:39,930 to invest in an education. Then, you'd spend every cent you make during your 30 00:02:39,930 --> 00:02:45,490 prime working years. Well, that sounds like a lot of fun. But without savings, 31 00:02:45,490 --> 00:02:50,910 your income will drop suddenly when you retire, and so will your consumption. 32 00:02:50,910 --> 00:02:52,500 Your golden years wouldn't be so golden. 33 00:02:52,500 --> 00:02:53,940 - [Doug from “King of Queens” TV series] [Kevin] If you're so smart, 34 00:02:53,940 --> 00:02:55,430 why don't you tell them that you live in my basement? 35 00:02:55,430 --> 00:02:56,900 - [Arthur] Why don't you tell them you're enormous? 36 00:02:56,900 --> 00:03:00,570 - [Doug] Why don't you tell them that your total salary last year was $12? 37 00:03:00,570 --> 00:03:03,730 - [Arthur] That was after taxes. 38 00:03:03,730 --> 00:03:10,990 - [Alex] So instead, people tend to follow a life cycle theory of savings. A person can 39 00:03:10,990 --> 00:03:17,960 start out consuming more than she makes, borrowing to fill that gap - and to pay for 40 00:03:17,960 --> 00:03:23,620 things like an education. Then, during her prime working years, she makes more than 41 00:03:23,620 --> 00:03:30,470 she consumes, paying down her debt and saving the extra income for retirement. 42 00:03:30,470 --> 00:03:36,600 And when retirement comes, she can spend those savings and enjoy the golden years even 43 00:03:36,600 --> 00:03:41,860 without working. Now of course, many people deviate from this exact path, 44 00:03:41,860 --> 00:03:43,690 depending on details. 45 00:03:43,690 --> 00:03:47,310 Most people, for example, they consume less in college than they do as 46 00:03:47,310 --> 00:03:53,860 professionals. Ramen noodles are no longer a staple of my diet. But generally 47 00:03:53,860 --> 00:04:02,250 speaking, many people follow a pattern of borrowing, saving, and dissaving to smooth 48 00:04:02,250 --> 00:04:07,100 their consumption path over their lifetime. Of course, just like some people 49 00:04:07,100 --> 00:04:11,720 can't wait until after dinner to reach for that cookie jar, not everyone saves and 50 00:04:11,720 --> 00:04:16,800 spends in the same way. How much you save and borrow depends upon your time 51 00:04:16,800 --> 00:04:22,250 preference. Some people - they're more impatient than others. We all know someone 52 00:04:22,250 --> 00:04:27,050 who spends everything they've got and doesn't save enough. On the other hand, if 53 00:04:27,050 --> 00:04:31,420 you're keeping to a budget and not spending too much so that you can go to 54 00:04:31,420 --> 00:04:38,640 college, well that's an example of being patient and waiting for higher consumption later. 55 00:04:38,640 --> 00:04:42,800 We've also learned from behavioral economics that saving is not just a matter 56 00:04:42,800 --> 00:04:49,520 of weighing costs and benefits. Nudges can matter. If your employer automatically 57 00:04:49,520 --> 00:04:55,330 enrolls you in a retirement plan, or sets a high default contribution rate, you'll 58 00:04:55,330 --> 00:04:59,870 probably end up saving more than if you have to choose yourself, even if choosing 59 00:04:59,870 --> 00:05:05,070 yourself would only take a few hours of work once in your lifetime. Another 60 00:05:05,070 --> 00:05:10,360 important reason to borrow is to make big investments. Just as students borrow to 61 00:05:10,360 --> 00:05:16,370 invest in education, businesses borrow to invest in big projects. Entrepreneurs with 62 00:05:16,370 --> 00:05:21,950 great ideas but not much money, they may have to borrow or sell a stake in their 63 00:05:21,950 --> 00:05:27,450 idea just to get their venture off the ground. For example, Howard Schultz built 64 00:05:27,450 --> 00:05:33,280 Starbucks into a global brand by borrowing and raising capital through several 65 00:05:33,280 --> 00:05:39,690 different types of financial intermediaries. We'll talk more about that in upcoming videos. 66 00:05:39,690 --> 00:05:43,660 As with any other good, we're going to use supply and demand to analyze the market 67 00:05:43,660 --> 00:05:48,140 for saving and borrowing, known as the Market for Loanable Funds. As we've seen, 68 00:05:48,140 --> 00:05:52,800 there are lots of good reasons to save and to borrow. But we have failed to mention 69 00:05:52,800 --> 00:06:00,650 one big factor - price. What's the price of saving and borrowing? It's the interest 70 00:06:00,650 --> 00:06:06,660 rate. So here's the supply curve showing the supply of savings. As the interest 71 00:06:06,660 --> 00:06:12,110 rate goes up, the quantity of savings supplied increases, and here's the demand 72 00:06:12,110 --> 00:06:18,010 curve showing the demand to borrow. Lower interest rates incentivize borrowing, so 73 00:06:18,010 --> 00:06:24,500 as the interest rate falls, the quantity of borrowing demanded increases. As with any 74 00:06:24,500 --> 00:06:30,560 other supply and demand graph, different factors will shift the curves. If a lot of 75 00:06:30,560 --> 00:06:34,930 people decide that it'd be a good idea to increase their savings, for example, then 76 00:06:34,930 --> 00:06:40,070 the supply of savings will shift outward. As you can see, this would cause interest 77 00:06:40,070 --> 00:06:45,300 rates to fall. This is what we saw in countries like South Korea and China, 78 00:06:45,300 --> 00:06:48,080 as their populations saved more. 79 00:06:48,080 --> 00:06:54,060 On the demand side, if investors, say became less optimistic for some reason, 80 00:06:54,060 --> 00:07:00,820 the demand to borrow would shift inward, causing the interest rate to fall. But if, 81 00:07:00,820 --> 00:07:05,720 say an investment tax credit from the government increased the demand to invest, 82 00:07:05,720 --> 00:07:09,720 then the demand curve will shift in the opposite direction, up and to the right, 83 00:07:09,720 --> 00:07:12,050 pushing interest rates up. 84 00:07:12,050 --> 00:07:16,790 Thinking about the Market for Loanable Funds helps us to see the big picture and 85 00:07:16,790 --> 00:07:21,430 understand the raw factors that determine interest rates and the quantity of 86 00:07:21,430 --> 00:07:26,390 borrowing and lending. But there isn't actually one market called the Market for 87 00:07:26,390 --> 00:07:32,160 Loanable Funds. It's not like the New York Stock Exchange. Instead, there are many, 88 00:07:32,160 --> 00:07:37,660 many, many markets for different kinds of borrowers and different kinds of lenders. 89 00:07:37,660 --> 00:07:42,190 And there are different types of institutions like banks, bond markets, and 90 00:07:42,190 --> 00:07:47,180 stock markets that connect the two sides of the market. We're going to delve more 91 00:07:47,180 --> 00:07:51,000 deeply into the different kinds of financial intermediaries, 92 00:07:54,530 --> 00:08:00,000 - [Narrator] If you want to test yourself, click "Practice Questions." Or, if you're 93 00:08:00,000 --> 00:08:04,800 ready to move on, you can click "Go to the Next Video." 94 00:08:04,800 --> 00:08:12,000 You can also visit MRUniversity.com to see our entire library of videos and resources.