Question

“Stages of development point out that financial development causes growth at the start of the modern development, but once the financial system is established, it mainly follows the real sector” (Hugh Patrick, cited in Todaro and Smith, 2011, p. 730).

(a) What is so important about the role of the financial system in economic development? Explain the six major functions that are important at the firm level and at the level of the economy as a whole?

(b) Explain the distinction between organized and unorganized money markets. As most developing countries have operated under a dual monetary system these nations have been faced with various problems. Explain the concepts of financial repression, financial liberalization, and currency substitution. How do they relate to financial policy in developing countries? Give examples to support your answer.

Answer 1

The financial system plays an important role in the economic development of the country. It represents a channel through which savings are mobilised from the surplus units and transferred to the deficit units.It helps in creation of wealth by linking savings and investments.It accelerates the rate and volume of savings through provision of various financial instruments and efficient mobilization of savings. It helps increasing the national output of the country by providing funds to corporate customers for expanding their business and protects the interest of the investors by allowing smooth  financial transactions through regulatory bodies like RBI SEBI etc.A financial system consists of financial institutions like banks,financial markets like money market,capital market, financial instruments like shares,debentures etc., financial services. All these components are closely related and work in close cooperation with each other. The government maintains a congenial business atmosphere only through financial system to ensure balanced growth of economy.

Six major functions which are important are as follows:-

1.Financial system helps in clearing and settling payments through banks and other financial institutions.

2.It provides various mechanisms for raising the capital required to start business such as security market and financial intermediaries.

3.Financial system helps in transferring funds from surplus units to deficit units through across time and space through various intermediaries like banks, insurance companies etc.

4.Through private sector and government intermediaries financial system helps in managing risk by providing risk pooling and risk sharing opportunities.

5.It hepls in descision making by proving information about security prices and interest rates which is used to take consumption saving decision and for choosing  a portfolio for allocation of wealth.

6.Financial system performs policy function through which government ensures smooth flow of funds in order to stabilize the economy.

Organized money markets consists of commercial banks, co operative banks and discount houses,acceptance houses and land mortgaged banks.The organized market is under the control of Central Bank while ann unorganized money markets consists of indigenous bankers and money lenders and is outside the control of central bank and therefore there is lack of uniformity in this market.

Financial repression consists measures taken by government by which government channels fund to themselves as a form of debt reduction.It included measures as lending to the government,caps on interest rates,regulation of capital movement between countries and a tighter association between govt. and banks.

Financial liberalization involved removal of government interventions from financial markets such as ceiling on interest rate, compulsory reserve requirement etc. leading to faster economic growth but can also increase the financial vulnerability of the country.

Currency substitution takes place when a country uses a foreign currency in place of,or in addition to its domestic currency because of greater stability of that foreign currency.It happens in developing nations,countries without a domestic currency and countries with unstable economic environment.

All these play an important role in financial policy of developing countries. The government can opt for preventing the development of certain financial institutions like banks instead of stock exchanges  in favour of others through financial repression.Secondly financial liberalization will increase savings which will spur investment and increase economic growth. Currency substitution will also help a developing country to use foreign currency in addition to domestic currency for example we are subsidizing dollar.