Figure 15-1 The Interaction of Firms and Households in the Capital
Market
that households are lending directly to non-bank borrowers. Households
may also decide to purchase stocks, thereby acquiring shares of firms.
Finally, some household saving is not done directly by households at all,
but rather by employers and the government in the form of employer-
sponsored and public pension plans (such as the Canada Pension Plan).
Whatever the form, households’ saving determines their total supply of
financial capital.
Figure 15-1 illustrates the interaction of firms and households in the
market for financial capital. Note that some funds flow directly between
firms and households (bond and stock purchases) whereas other funds
flow through financial intermediaries (bank deposits and loans). Financial
intermediaries play an important role in the economy for two reasons.
First, they are specialists in assessing the riskiness of potential borrowers
and thus are better suited than most households to making loans to firms.
Second, they have the ability to pool the savings from a large number of
households and thereby make large loans to firms. Despite the
importance of financial intermediaries to the economy, in this chapter we
will focus our attention on households and firms, thus focusing on the
fundamental determinants of the demand for and supply of financial
capital.