Savings, Investment Spending, and the Financial System

• Module 20: Savings and Investment Spending
• Module 21: The Market for Loanable Funds
• Module 22: The Time Value of Money
• Module 23: The Financial System

FUNDS FOR FACEBOOK

“Facebook Is Hunting For More Money”—so read a headline in Business Week, which reported that the social networking site was seeking to secure a $100 million credit line. Why would a wildly successful business like Facebook need to borrow money?

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. Currently, Facebook has more than a billion users worldwide. 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 borrowed.

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 is 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 section 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 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 channeled funds into investment spending projects such as railroads and factories. Today, financial systems 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 section, we begin by focusing on the economy as a whole. We examine the relationship between savings and investment spending. Next, we look at the financial system to see how savings is transformed into investment spending, as well as the role that time plays in financial decision making. We’ll also look at how the financial system works to increase the welfare of savers with funds to invest as well as those with investment spending projects to finance.