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♪ [music] ♪

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[Alex] On September 15, 2008,

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the world's financial system
was shaken to its core

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when the investment bank,
Lehman Brothers,

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filed for bankruptcy.

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The impact was great not simply
because Lehman was big,

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but also because it was
an important financial intermediary,

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an institution that
helps bridge the gap

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between savers and borrowers.

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

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that signaled
the worst economic downturn

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since the Great Depression.

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And while there's several
significant angles

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to the Great Recession,

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one of them was
the decreased efficacy

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of financial intermediation.

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Now, some later videos
are going to go through this

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in more detail.

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

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as to why financial intermediation
is so important.

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We'll start
with the supply of savings

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and the demand to borrow,

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and the market
which brings them together --

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the Market for Loanable Funds --

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and then we'll work our way up

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to an examination
of The Great Recession.

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So why do people borrow
and save at all?

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

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

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They change in predictable ways.

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Here's a typical pattern,

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showing a person's income
over their life,

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with their income
on the vertical axis

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and time on the horizontal axis.

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When you're young
and still in school,

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you might make
a little bit of money,

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waiting tables
or occasionally mowing lawns.

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

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and after a few years
of experience

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and hopefully
a few raises along the way,

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you make more than you ever have.

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

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when your income falls.

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But you're no longer working

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and you could really enjoy 
your golden years.

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

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

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

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For you! I'm so happy for you!”

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[Alex] Now, let's imagine

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if your consumption followed
the same path as your income

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and you never saved or borrowed.

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You'd struggle when young,

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

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Then, you'd spend
every cent you make

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during your prime working years.

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Well, that sounds
like a lot of fun.

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But without savings,
your income will drop suddenly

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when you retire,
and so will your consumption.

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Your golden years
wouldn't be so golden.

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

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

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

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[Doug] Why don't you tell them

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that your total salary
last year was $12?

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[Arthur] That was after taxes.

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[Alex] So instead,
people tend to follow

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a life cycle theory of savings.

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A person can start out consuming
more than she makes,

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borrowing to fill that gap --

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and to pay for things
like an education.

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Then, during
her prime working years,

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she makes more than she consumes,
paying down her debt

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and saving the extra income
for retirement.

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And when retirement comes,
she can spend those savings

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and enjoy the golden years
even without working.

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

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depending on details.

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Most people, for example,
they consume less in college

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than they do as professionals.

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Ramen noodles are no longer
a staple of my diet.

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But generally speaking,
many people follow a pattern

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of borrowing, saving,
and dissaving

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to smooth their consumption path
over their lifetime.

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

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to reach for that cookie jar,

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not everyone saves and spends
in the same way.

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

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

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We all know someone
who spends everything they've got

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and doesn't save enough.

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

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

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well that's an example
of being patient

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and waiting
for higher consumption later.

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We've also learned
from behavioral economics

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

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Nudges can matter.

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If your employer automatically
enrolls you in a retirement plan,

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or sets a high
default contribution rate,

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you'll probably end up saving more

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than if you have to choose yourself,

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

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once in your lifetime.

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Another important reason to borrow
is to make big investments.

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Just as students borrow
to invest in education,

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businesses borrow
to invest in big projects.

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Entrepreneurs with great ideas
but not much money,

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

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just to get their venture
off the ground.

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For example, Howard Schultz
built Starbucks into a global brand

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by borrowing and raising capital

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through several different types
of financial intermediaries.

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We'll talk more about that
in upcoming videos.

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As with any other good,

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we're going to use
supply and demand

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to analyze the market
for saving and borrowing,

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known as the Market
for Loanable Funds.

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

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to save and to borrow.

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

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What's the price
of saving and borrowing?

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It's the interest rate.

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

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As the interest rate goes up,

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the quantity
of savings supplied increases,

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

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Lower interest rates
incentivize borrowing,

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so as the interest rate falls,

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the quantity
of borrowing demanded increases.

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As with any other
supply and demand graph,

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different factors
will shift the curves.

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

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to increase their savings,
for example,

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then the supply of savings
will shift outward.

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

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

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as their populations saved more.

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On the demand side,
if investors, say

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became less optimistic
for some reason,

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the demand to borrow
would shift inward,

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causing the interest rate to fall.

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But if, say an investment tax credit
from the government

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increased the demand to invest,

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then the demand curve will shift
in the opposite direction,

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up and to the right,
pushing interest rates up.

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Thinking about the Market
for Loanable Funds helps us

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to see the big picture
and understand the raw factors

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that determine interest rates

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and the quantity
of borrowing and lending.

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But there isn't actually
one market

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called the Market
for Loanable Funds.

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It's not like the New York
Stock Exchange.

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Instead, there are many,
many, many markets

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for different kinds of borrowers
and different kinds of lenders.

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And there are different types
of institutions like banks,

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bond markets, and stock markets

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that connect
the two sides of the market.

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We're going to delve more deeply

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into the different kinds
of financial intermediaries,

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and why they're so important, next.

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[Narrator] If you want
to test yourself,

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click "Practice Questions."

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Or, if you're ready to move on,

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you can click 
"Go to the Next Video."

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to see our entire library
of videos and resources.

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♪ [music] ♪