Is There Any Relationship Between Financial System And Development?

Is there any relationship between financial system and development? Lombard Street: A Description of Money Market

 Walter

Bagehot

in

his

book

published in 1873 talked about the role of financial institutions in economic development in England.  J.M.

of

Keynes in his book-General Theory

Employment,

Interest

and

written in 1936 emphasised on relationship between finance economic development.

Money the and

Is there any relationship between financial system and development? 

Joseph Schumpeter in his book-Theory of Economic Development published in 1934 talks about the relationship between credit (a form of finance) and innovation which causes economic development.

"The banker stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development, though only when no central authority directs the social process. He makes possible the carrying out of new combinations, authorises people, in the name of the society as it were, to form them. He is the ephor of the exchange economy.”

Is there any relationship between financial system and development? Schumpeter further said, “The relation between credit creation by banks and innovation is fundamental to the understanding of the capitalist engine." Robert G King, and Ross Levine (1993) “Finance and Growth: Schumpeter Might Be Right.” Quarterly Journal of Economics 108 (August): 716–37.

Is there any relationship between financial system and development?  Alexander

Gerschenkron

in

his

book-

Economic Backwardness and Historical Perspective: A Book of Essays published in 1962 talked about the necessity of financial institutions to kick start the industrial development. Rondo

Cameron in his book- Banking

in Early Stages of Industrialisation: a Study in Comparative Economic History published in 1967 emphasised on the financial system and its role on economic development in developed countries.

Is there any relationship between financial system and development? Robinson,

J. (1952), „The Generalisation of the General Theory‟, in her book- The Rate of Interest and Other Essays said :

“...Where enterprise finance follows.”

leads,

What is economic development?  It

indicates a situation of growing betterment of individuals in the society. In economics it relates to material well-being which is determined by production of goods and services.

 Economic

development refers to growth of GDP with its balanced distribution in the society.

Examples of role of finance in economic development.  Financial

system through bringing together the savers and investors promote the production of goods and services.

(a)Financial sector.

flows

to

agriculture

(b)Financial flows to industrial sector. (c)Financial flows to service sector. (d)Financial flows to speculative stock markets?

Theories of relationship between finance and economic development 1.

Prior savings theory

2.

Credit creation theory

3.

Theory of forced savings

4.

Financial regulation theory

5.

Financial liberalisation theory

Prior Savings Theory  This

theory regards saving as a prerequisite or a determinant of investment. It holds that all savings in the economy can find investment outlets.

 According

to this theory if Investments exceed savings then it generates inflation in the economy.

 Therefore

there should be an emphasis on mobilisation of savings from each nook and corner of the country to raise the availability of savings to finance higher level of investments.

Loanable Funds Theory as part of prior saving theory r

I

S S1 E

r1 E1 r2

S1=I1 S2=I2

S, I

Financial intermediation and production possibility frontiers X

PPF

PPF1 Y

The role of financial intermediaries in shifting the PPFs  They

reduce the cost for searching investment opportunities for individuals.

 They

verify the soundness investment projects.

 Monitoring

the use which it was lent.

 Enforcement

borrowers interest.

of

of

the

funds

for

of rules to ensure the repay the loans with

The role of financial intermediaries in shifting the PPFs  They

perform as the source of development by adopting the following transformation services:

(a). Liability-Asset Transformation (b). Size-Transformation (c). Risk-Transformation

(d). Maturity-Transformation

Credit Creation Theory  This

theory accepts that savings do not constraint the investments given the banking system.

 This

theory is based on the concept of inside-money.

 This

theory can be understood by looking at the role of banks in creation of demand deposits in a fractional reserve system with multiple banks.

 Kalecki

and Schumpeter were supporters of this theory.

the

main

Theory of Forced Savings  This

theory establishes that investments is financed by

ex-ante ex-post

savings.  It

was argued by J.M. Keynes and James Tobin.

 Investment

rather saving.  If

is not determined by savings investment determines its own

there is monetary expansion to finance investment over saving then if there is excess capacity in the economy it will generate income and therefore matching savings.

Theory of Forced Savings 

At full employment rise in investment will increase inflation that will reduce the real interest rates and this cause shift in portfolio-pattern causing people to use more capital intensive techniques which causes output and savings to rise. This is called portfolio or Tobin‟s effect.



At full employment if investment increases it leads to inflation which benefits the capitalists and that causes there income to grow and therefore savings. This is know as distribution effect.

Financial Regulation Theory  This

theory is primarily based on the article written by G.A. AKERLOF (1970) “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics, Vol. 84 (1970), pp. 488–500 and Joseph Stiglitz and A. Weiss(1981), “Credit Rationing in Markets with Imperfect Information”,

American Economic Review, Vol. 71, pp. 393-410.  Both

were awarded Nobel Prize with A. Michael Spence in 2001.

Financial Regulation Theory 

There is imperfect information in the market.



If there is no control over interest rates then bad borrowers will replace good borrowers ultimately to cause the failure of repayments.

 If

there is too much competition that will lead to frequent change of the lenders which will create greater degree of asymmetric environment in the economy.

Financial Liberalisation Theory 

Ronald I. McKinnon(1973), Money & Capital in

Economic Development. 

E.S. Shaw(1973), Financial Deepening in Economic Development.



McKinnon and Shaw are main proponents of the Financial Liberalisation Theory.



They argued against the financial regulation theory by calling the regulated economies as financially repressed economies.

Indicators of Financial Repression  Lower

savings and inefficient investments.

 Existence

of indiscriminate distortions:

(a) Directed credit;

(b) Controlled interest rates regimes; (c) Controlled exchange rates; (d) Prescription of high reserve ratios. ..\Major monetary policy rates.pdf and..\Major monetary policy rates-2006 onwards.pdf

Distortions cause the problems  Bias

towards consumption and against savings.

 Promoting

capital intensive industries.

 Promoting  Making

low yielding investments.

investors not to investigate alternative investments and proposing better management in their organisation.

Positive effects of financial liberalisation  Increase

in Interest rates.

 Increase

in savings.

 Increase

in efficient investments.

 Increase

in better financial services.

 More

options for saving mobilisation.

 Innovation

of financial instruments which make the payment system more efficient and better suited for customers.

What is financial development? 

Finance Inter-relation Ratio (FIR): Ratio of Financial assets to physical assets.



New Issue Ratio (NIR): Ratio of primary issues to physical capital formation.



Intermediation Ratio (IR): Ratio of secondary issues to Primary issues.



Ratio of Money supply to total GDP.



Lower information costs also imply financial development.



Greater openness of financial system is an indicator of larger financial assets.

What is Flow of Funds (FOF) Accounts? 

FOF represents systematic record of net transactions involving financial instruments during a given period of time.



All the participants in financial activities be grouped into few sectors (in India it six); and all the financial claims can grouped into few instruments (in India it ten).



Following the system of double entry bookkeeping in financial accounting, the transactions between participants could be treated in quadruple entry form.



The FOF is prepared usually quarterly annually and presented in a matrix form.

can is be is

or

What is Flow of Funds (FOF) Accounts?  Row-wise

entries show flow of funds into different sectors; while column-wise entries show receipts from various sectors.

 FOF

reveals the overall surplus or deficit of a sector.

 FOF

also expresses changes in assets and liabilities of different sectors.

 FOF

represents a comprehensive picture of an economy where policy makers can identify where to put funds and what kind of financial policy to follow during different business climates.

What is Flow of Funds (FOF) Accounts?  FOF

is also presented in terms of sectors and forms of instruments which bring up the change in assets and liabilities of sector during a period of time.

 The

convention is to treat increase in assets of a sector as uses of funds and increase in liabilities as sources of funds.

 ..\Flow

of funds in India.docx