Loanable Funds Market

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.