Anirban
However the effects of Financial system on economic development can be understood by analyzing the following three effects it has on the economy:
A) Technological Progress is an endogenous factor which requires higher saving and investment which in return gets facilitated through the financial system
B) Capital Formation: Economic development depends to a great extent on the rate of capital formation. Relationship between capital and output is strong, direct and monotonic. Availability of capital at the correct time and amount depends on the efficacy of the Financial system.
C) Amplification of Markets over space and time:
Secondly, the credit created leads to investment which generates the appropriate level of income which in turn leads to an amount of savings which are equal to the investment already undertaken-in the process keeping the system in equilibrium
The theory states that in an economy with unemployed resources, an increase in investment will lead to an increase in aggregate demand, output and savings.
Secondly, even if the resources are fully employed, any expansionary policy will lead to inflation. Here inflation should be treated as a positive effect as it leads to reduction in real rate of return on financial assets which forces people to invest in physical assets leading to an increase in output and savings.
Indicators of Financial Regulation and Repression in an economy: A: Indiscriminate distortion in financial variables like interest rates and exchange rate B: Imposition of Ceilings on Interest rates C: Prescribing High Reserve ratio D: Undesirable Directed Credit Program E: Restrictive EXIM Policy
Then why has Financial liberalization failed in numerous occasion? Most common reasons cited are as follows: 1: Existence of implicit or explicit deposit insurance 2: Lack of Banking supervision 3: Macroeconomics instability 4: Excessive risk taking by banks
Financial Assets/Securities/Claims
Definition of a Financial asset: a claim to the payment of a sum of money sometime in the future (repayment of a principal) and/ or a periodic payment in the form of interest/dividend . For example, a Bond with a Face value of Rs 1000, a Coupon rate of 12%, maturity of 5 years and redeemable at par implies that the holder of the instrument would receive the following set of Cash flows
120
120
120
120
1120
Indirect Financing
Indirect financing useful if SSU and DSUs have difference in preferences for Amount / Maturity / Risk / Liquidity (marketability) . Indirect financing - Financial intermediaries transform claims: raise funds by issuing claims to SSUs; use funds to buy claims issued by DSUs. Claims can have unmatched characteristics: SSU has claim against intermediary; Intermediary has claim against DSU.
Common intermediaries Commercial Banking - Take deposits and make loans Depositors are SSUs. Borrowers are DSUs.
Insurance Co - Issue policies, collect premiums, invest in stocks and bonds. Policyholders are SSUs; Businesses or governments are DSUs.
In a nutshell Financial Institutions and Intermediaries promote development through the following below mentioned functions:
A: Liability-Asset Transformation: Deposits from savers converted to Advances and Loans for Borrowers B: Size Transformation: Small deposits pooled from savers passed as Corporate Loans. C: Risk Transformation: Pool, distribute, reduce and manage risk through greater diversification D: Maturity Transformation: Offers savers alternate forms of deposits (Current, Term) and provide borrowers with loans of various maturities (Short Term,
Financial markets are critical for producing an efficient allocation of capital, which contributes to higher production and efficiency for the overall economy, as well as economic security for the citizenry as a whole Financial markets also improve the lot of individual participants by providing investment returns to lender-savers and profit and/or use opportunities to borrower-spenders. Enabling economic units to exercise their time preference Separation, distribution, diversification and reduction of risk Efficient payment mechanism Providing information Enhancing liquidity Providing portfolio management services.
- Facilitates economic activity and growth - Helps accelerate the volume and rate of savings. - Lowers financial intermediation costs - Makes innovation least costly - Helps in evaluating assets - Helps in central bank to conduct monetary policy