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Lecture 9 - Finance and Fiscal Policy The financial system plays a key role in the process of economic development which the government can encourage by adopting sound macroeconomic policies to provide financial systems where they don't exist and regulating financial markets. It is harder for LDC govs to do so;
- Some financial policies have led to low domestic savings and inefficiencies within the banking system.
- Current tax structures often work against attempts to restore fiscal balance.
- Countries are critically constrained by public administration. ROLE OF THE FINANCIAL SYSTEM Has six major functions as follows.
1. Provider of payment services. Replaces cash which is inconvenient, inefficient and risky to carry around when paying for goods and services. E.g. debit and credit cards.
2. Matching savers and investors. Important that savers and investors can meet and agree on terms of loans or other finance in an efficient manner.
3. Creating and distributing information. Financial markets represent the brain of the economic system, able to devise perceived values representing the average judgement of most investors.
4. Allocating credit efficiently. Channelling investment funds to uses that yield the highest rate of return allowing increased specialisation and division of labour.
5. Pricing, pooling and trading risks. Insurance markets and diversification of stock markets provide protection against risk.
6. Increasing asset liquidity. Enables more convenient trading of assets. Macroeconomic stability aims to get inflation under control, restore fiscal balance (through reduced gov expenditure and increased taxes) and eliminate the current account deficit over control of the ER and promotion of exports. Monetary policy is based on the money supply and interest rates both of which are key in controlling inflation. Such variables determine the level of economic activity: recessions, upturns, borrowing, consumption etc. LDC MONEY MARKETS Tend to be less efficient due to lower availability of technology, also the main aim is not to serve the local population and the health of the local economy is not as much a priority to many participants in the market processes. Most LDC financial institutions and markets are highly unorganized, unorganized, externally dependent and spatially fragmented. Many are just branches of major banking institutions from developed countries so are more concerned with external monetary situations. LDC govs also find regulation of the money supply due to the openness of their economies with many currencies pinned to the $ or a basket of MDC currencies. Therefore official gov actions and measures end up serving only the wealthy. Limited info and incomplete credit markets result in LDCs with commercial banking systems that lack transparency (full disclosure of the quality of loan portfolios. ROLE OF CENTRAL BANKS In developed countries they conduct a wide range of banking, regulatory and supervisory functions through public responsibilities and supervisory functions. Mostly 5 general functions:
1. Issuer of currency and manager of foreign reserves. The bank prints money, distributes coins and notes, manages the foreign-asset reserves and the ER by intervening in foreign-exchange markets.
2. Banker to the gov. Providing bank deposit and borrowing facilities to the gov whilst acting as its fiscal agent and underwriter.
3. Banker to domestic commercial banks. Providing bank deposits and borrowing facilities and lending to financially troubled commercial banks.
4. Regulator of domestic financial institutions. Using relevant laws and regulations, they also monitor reserve ratio requirements and supervise the conduct of local and regional banks.
5. Operator of monetary and credit policy. Attempting to use monetary and credit policy instruments to control inflations, promote investment and regulate international currency movements. This issue with developing countries is the characteristics of their financial systems. Such as (a) foreign owned commercial banks, (b) informal and exploitive credit network, (c) central banks that have inherited roles from colonial rulers and therefore act as currency boards issuing domestic currency for foreign exchange at fixed rates, (d) money supply that is hard to measure, (e) unskilled workforce and (f) a degree of political influence over interest rates, foreign ERs and import licences.
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