We've talked about how

when households save money

is not somehow loss to the economy.

It's loaned down to businesses

who use it to invest in capital,

but today we are going to get

into the specifics of how that happens.

So you have got households

who haven't consumed

all of their income.

They want to turn those savings

into more money in the future.

Also you got businesses

that need capital;

things like office buildings,

delivery trucks, computers,

stores, or bulldozers.

That capital will produce more output

and therefore more money

for those businesses in the future.

But in the real world

how do we link up the savers

with the borrowers?

That's one of the main jobs

of the financial system.

Obviously, the financial system

is massively complicated

but we can boil it down

to three main pipelines

between savers and borrowers.

The first of these are banks.

Households may deposit their savings

in a bank.

The bank will hold onto some of that money

but it will loan out most of it to businesses

looking to invest in capital.

With the additional income from that capital,

those businesses will pay interest

and eventually the principal

back to the bank.

The bank in turn

pay some of that interest back

to its depositors.

Typically the interest rates

the borrowers pay to the bank

are higher than the interest rates

the bank pays to its depositors.

So if Jane's warehouse

is paying downtown bank 5% on the loan

that it took out to buy a forklift,

downtown bank may only be paying

its depositors 2% interest.

The reason for that is that

downtown bank needs to build up a buffer

against a couple different kinds of risk.

First Jane's warehouse might go bankrupt

and stop paying on its loan.

Second, if interest rates

in the wider market rise,

downtown has to pay its depositors more

just to keep up with its competitors

but it can't go back

and raise the interest rate

on Jane's warehouse.

Third, any depositor is allowed to withdraw

all of their money at any time

even though most of it has been loaned out.

The bank needs to keep a buffer

in case more depositors than expected

pull out their money.

So the bank is essentially a company

that gets paid to act not only

as a connector of lenders and borrowers

but also to act like a big shock absorber.

It's paid to insulate depositors

from bankrupt borrowers

and borrowers from higher interest rates.

The second pipeline

between savers and borrowers are bonds.

When a government or large company

wants to borrow money

they may issue a bond

which is essentially an I Owe You.

The bond carves three numbers in stone;

the amount being borrowed,

the date at which it must be repaid

which is called maturity,

and the interest rate

that the borrower will pay in the meantime.

The borrower gets cash from the lender

and the lender gets the bond.

The lender can then sell that bond

to a third-party for more cash.

Now that third-party

will receive the interest payments

and if they hold onto the bond until maturity,

they will also receive

the principal repayment.

Again the borrowers use the increased revenue

from their new capital

to pay back the interest and the principal.

There is a thriving market for these bonds

among third-party investors.

The bond market

has its own supply and demand.

The prices paid for those bonds

change all the time

in response to supply and demand

and need not equal the amount

of the bond's principal.

For reasons that would take

a whole video to explain

on prices and bond interest rates

always move in opposite directions.

The third pipeline

between the lenders and borrowers

is the one you've probably heard

the most about.

It's the stock market.

When a company reaches a certain size

it may decide to raise funds

by issuing stock.

Investors give cash to the company

in exchange for stock

at an initial public offering or IPO.

As with bonds those initial stockholders

can then sell those stocks to third parties

on the stock market.

Each share of a stock

is a tiny slice of ownership of the company.

So if Slugs R Us

has issued 2000 shares of stock

and I own 60 of them

I essentially own 3% of Slugs R Us.

That entitles me to 3% of their profits.

They can get that money back to me

in a couple of different ways.

They could issue dividend payments

although not all companies do this,

or they could buy back their stock from me

at a premium leaving me with a capital gain,

or I could sell their stock at a gain

to some other investor

who's hoping for one of those types

of repayment in the future.

Borrowing through banks and bonds

is similar in that both transactions

involve debt obligations.

In a debt obligation

the amount to be repaid is fixed

regardless of the profitability

of the borrower.

In contrast,

stocks represent equity obligations.

The lender is entitled

to a small fraction of the firm's profits.

So if the firm does well

it pays out a lot

and the investor gets a lot,

but if the firm goes bankrupt it pays nothing

and the stocks become worthless.

The bond and stock pipelines

between savers and borrowers

also have something in common.

They are markets for financial assets.

The process of linking savers and borrowers

is decentralized

among thousands of market participants

buying and selling pieces of paper

that represent claims on future income.

In contrast,

banks are considered financial institutions.

They are companies

with buildings and employees and cubicles

and they are paid to safeguard deposits,

make loans, and absorb risk.