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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♪ [music] ♪

- [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

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,

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