FACEBOOK WENT PUBLIC ON May 18, 2012. Its initial public offering (IPO) captured headlines around the world because it was one of the largest technology sector IPOs in history. Becoming a publicly traded institution allowed Facebook to raise funds from the financial market more easily. Why would a wildly successful business like Facebook need to attract new capital?

Everyone knows Facebook. Founded in 2004, it has gone on to become arguably the biggest business success story of the twenty-first century—so far. According to Socialbakers, one of the most cited and fastest growing social media analytics companies, as of August 2012 there were about 17.7 million Facebook users in Canada. This represents a population penetration rate of 53%. How did Facebook grow so big, so fast?

In large part, of course, the answer is that the company had a good idea. Personalized web pages providing information to friends turned out to be something many people really wanted. Equally important, since advertisers wanted access to the readers of those pages, Facebook could make a lot of money selling advertising space.

But having a good idea isn’t enough to build a business. Entrepreneurs need funds: you have to spend money to make money. Although businesses like Facebook seem to exist solely in the virtual world of cyberspace, free of the worldly burdens of brick-and-mortar establishments, the truth is that running such businesses requires a lot of very real and expensive hardware. Like Google, Yahoo!, and other Internet giants, Facebook maintains huge “server farms,” arrays of linked computers that track and process all the information needed to provide the user experience.

So where did Facebook get the money to equip these server farms? Some of it came from investors who acquired shares in the business, but much of it was borrowed. As Facebook grew bigger, so did the amount it needed to raise.

The ability of Facebook to raise large sums of money to finance its growth is, in its own way, as remarkable as the company’s product. In effect, some young guy with a bright idea was able to lay his hands on hundreds of millions of dollars to build his business. It’s an amazing story.

Yet this sort of thing is common in modern economies. The long-run growth we analyzed in the previous chapter depends crucially on a set of markets and institutions, collectively known as the financial system, that channels the funds of savers into productive investment spending. Without this system, businesses like Facebook would not be able to purchase much of the physical capital that is an important source of productivity growth. And savers would be forced to accept a lower return on their funds. Historically, financial systems channelled funds into investment spending projects such as railroads and factories. Today, financial systems also channel funds into new sources of growth such as green technology, social media, and investments in human capital. Without a well-functioning financial system, a country will suffer stunted economic growth.

In this chapter, we begin by focusing on the economy as a whole. We will examine the relationship between savings and investment spending. Next, we go behind this relationship and analyze the financial system, the means by which savings is transformed into investment spending. We’ll see how the financial system works by creating assets, markets, and institutions that increase the welfare of both savers (those with funds to invest) and borrowers (those with investment spending projects to finance). Finally, we examine the behaviour of financial markets and why they often resist economists’ attempts at explanation.