CH15,12 - Week 08 Finance Fiscal Policy for Development The...

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Week 08: Finance & Fiscal Policy for Development The Role of the Financial System The financial sector provides six major functions that are important both at the firm level and at the level of the economy as a whole. 1) Providing payment services -It provides efficient ways such as personal commercial checking, credit/debit card. 2) Matching savers and investors -The presence of banks and later venture capitalists or stock markets, can greatly facilitate matching in an efficient manner. 3) Generating/distributing information -One of the most important functions is to generate, collect and distribute information which if formed the most important components of the ‘capital’ of bank. 4) Allocating credit efficiently -It increases in the specialisation and division of labour. 5) Pricing, pooling, and trading risks -Insurance markets provide protection against risk and diversification possible in stock market. 6) Increasing asset liquidity -Financial development increases liquidity by making investments esp. long-lived easier to sell. The Bumpy Road to Macroeconomic Stability For effective functioning of the financial system requires the precondition of macroeconomic stability. Macroeconomic stabilisation has three main objectives: (1) Controlling inflation (2) Restoring fiscal balance -Through reduced government expenditures, raising personal and business taxes and reforming the financial system. (3) Eliminating the current account deficit -Through control over the exchange rate (devaluation) and promotion of exports. The two principal catalysts for the above stabilisation are IMF and World Bank. The pursuit of financial stabilisation and structural adjustment would bring a slowdown in economic growth and a worsening of domestic poverty and inequality. Financial Systems and Monetary Policy Difference between MDC and LDC financial systems -The monetary policy in developed countries showed two important aspects that developing countries lack. -The ability of developed-country governments to expand and contract their money supply, and to raise and lower the costs of borrowing in the private sector (thru direct or indirect manipulation of interest rates) is made possible by the existence of highly organised, economically interdependent, and efficiently functioning money and credit markets.
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-Interest rates are regulated both by credit controls and by market forces. Which leads to consistency and uniformity of rates. Financial intermediaries are thus able to mobilise private savings and efficiently allocate them to their most productive uses. The role of central banks 1 – Issuer of currency and manager of foreign reserves 2 – Banker to the government 3 – Banker to domestic commercial bank 4 – Regulator of domestic financial institutions 5 – Operator of monetary and credit policy (Table 15.1) -LDCs may be dominated by a narrow range of exports accompanied by a much larger diversity of imports, the relative prices (TOT) of which are likely to be beyond local control. Their financial systems tend to be rudimentary and characterised by:
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