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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]
[Kevin] 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.
[Narrator] If you want
to test yourself,
click "Practice Questions."
Or, if you're ready to move on,
you can click
"Go to the Next Video."
You can also visit MRUniversity.com
to see our entire library
of videos and resources.
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