The Functions of the Financial System | Economics Essay

The Functions of the fiscal System Economics EssayIntroductionThe objective of this chapter is to provide a theoretical and data-based literature re adopt of the kinship amongst pecuniary tuition and stinting harvest-festival in general and more narrowly at firmamental growth analysis. Therefore, it is important to determine what fiscal development relates to, how the financial sector and over wholly economy are related to each other, and the implications of such a kin for other sectors of the economy.In the following of this chapter, the study will first review the theory of financial development, whereby explaining the model of financial formation and how they affect growth of the real sector. The next section will accent on those authors who believe that economic growth is a good predictor of financial sector development. Further, effects of financial development on various sectors growth will be discussed. The next section will review the existing empirical studies examining the human relationship of FD and growth.Theoretical BackgroundFinancial SystemA financial administration is a ne cardinalrk of markets and institutions that bring savers and borrowers together (Hubbard, 1997). Financial systems have become the keystone of more or less economies approximately the world. This field is of great interest to economists, who research mainly the causes and impacts of its development. Through years, economists has changed their perceptive has about the nature of the relationship between financial systems and economic growth. Bagehot (1873) established the pioneering theory on the relation between financial system and economic growth in his book Lombard Street A Description of the Money Market (1873). He found that financial markets facilitate the accumulation of capital and these markets manage the risk from relative investments and business st assessgies.Later, Schumpeter (1911) identify that financial intermediaries facilitate proficient in novation by gathering savings, evaluating investment projects, monitoring managers and facilitating transactions. The main stock of Schumpeter was that financial development affects economic growth done technological changes and this is done by banking institutions than stock markets. agree to the Schumpeterian model, banks create entrepreneurs who carry out new investment projects that lead to economic growth as these sneak in investment opportunities are operational due to new combinations of providing finance to entrepreneurs.Following, thither were Goldsmith (1969), McKinnon (1973) and Shaw (1973) who forceful on the portion of capital accumulation in economic growth. In the McKinnon-Shaw model, a well demonstrable financial system mobilises savings by channeling small valued savings into profitable large carapace investments. According to them, without a proper participation of financial system, these savings might not be available for further investment because a fina ncial institution mobilises savings from various savers in an efficient and rough-and-ready way by avoiding information asymmetries and lowering transaction costs. Unlike Schumpeter, they did not distinguish between the banking sector and the stock market. For them, both of markets are important in the process of economic growth.Although Schumpeter (1911), McKinnon (1973), Shaw (1973) and other economists emphasised on the positive reference of financial development on economic growth, they failed to explain clearly how channeling of those funds affects growth. therefore came Levine (1997, 1999), who has first depicted this plug in clearly. Levine demonstrated five main functions of the financial markets that affect the economic growth. much specifically, Levine pointed out that financial systemFacilitate the trading, hedging, diversifying, and pooling of risk,Monitor managers and apply corporate control,Allocate mental imagerys,Mobililize savings, andFacilitate the transform of goods and services.Functions of Financial SystemUnlike other economists, Levine (1999) produced a comprehensive way of showing the significant role for financial markets. The impact on economic growth occurs through the following channels according to Levine.As discussed above, financial markets play a significant role in economic growth through their role of allocation capital, monitoring managers, mobilizing of savings and promoting technological changes among others. Economists had held the view that the development of the financial sector is a polar element for stimulating economic growth. Financial development can be defined as the business leader of a financial sector acquire effectively information, enforce contracts, facilitate transactions and create incentives for the process of particular types of financial contracts, markets and intermediaries, and all should be at a low cost.1Financial development occurs when financial instruments, markets and intermediaries amel iorate through the basis of information, enforcement and transaction costs, and therefore better provide financial services. The financial functions or services may influence saving and investment decisions of an economy through capital accumulation and technological innovation and hence economic growth. Capital accumulation can either be modeled through capital externalities or capital goods produced using constant returns to scale but without the use of any coherent factors to generate steady-state per capita growth.2Through capital accumulation, the functions performed by the financial system affect the steady growth rate thereby influencing the rate of capital formation. The financial system affects capital accumulation either by fixing the savings rate or by reallocating savings among different capital producing levels. Through technological innovation, the focus is on the invention of new production processes and goods.3As market frictions and laws, regulations and policies differs to a greater extent crosswise economies and over time, the impact of financial development on growth may have different implications for resource allocation and welfare in the economy.Relationship between Financial Development and Economic Growth(i) get in touch of financial development and real sectors of the economyThe theoretical evidence that financial sector development fosters economic growth has been accumulating over many decades. Schumpeter (1911), McKinnon (1973), Shaw (1973) Goldsmith (1969), Levine (1999) and other proponents came with a clear understanding of the role of financial development on economic growth. However, these theories do not provide a clear explanation of the contagious disease of financial development to the real sector of the economy thats lead to growth. Recently, some researchers have translated these abstract cogitate between financial development and economic growth into concrete channels, such as household consumption, investment, sl ew (exports and imports) and government spending. Consequently, any increase from household consumption, investment, trade and government spending will have a positive impact on the real sector of the economy, and on the growth of economies. This link is illustrated belowYt= Ct+ It+ (Xt-Mt) + Gt, whereYt is the gross domestic product, Ct is household consumption, It is domestic investmentXt is exports, Mt for the imports and Gt is government spending.Financial development and household expenditure are highly correlated, as discussed in Claessens and Feijen (2006). They argued that despite the causal relationship between financial development and household consumption is less clear than in the case of income, there is evidence that financial development is a leading indicator for increases in household consumption. Apart from change magnitude the household welfare, financial development also increases investment through the allocation of capital to private sector. The man Business Environment Survey (WBES), recent research concludes that finance is the most important constraint on firm growth. Other studies such as, Rajan and Zingales (1998), Perotti and Volpin (2005) have found that the number of firms in an industry grew faster in counties that have better financial development. Claessens and Feijen (2006) also highlighted that the presence of financial intermediaries with their products such as credit cards, account cards facilitate domestic and international payment service whereby facilitating trade. The Claessens and Feijen framework hence has demonstrated the link between financial development and economic growth through concrete channels.(ii) Finance- Growth NexusIn the traditional development economics, there exist two distinct views of the finance-growth nexus. The first view was first proposed by Schumpeter (1911) who argues that services provided by financial intermediaries are essential drivers of innovation and growth. Thus, well-developed fina ncial systems channel financial resources to their most productive use. The Schumpeters view was later formalised by Goldsmith (1969) McKinnon (1973) Shaw (1973) King and Levine (1993) Pagano (1993) Fry (1995) Zervos and Levine (1996, 1999) Christopoulos (2004) Manoj and Kamat (2007) and Hasan, Watchel and Zhou (2008) where all believed that financial development is a catalyst for economic growth.The second view suggests that economic growth is the major driving force behind the development of the financial sector. This idea is very much stressed in the work of Robinson (1952). According to him, as an economy grows, more financial institutions, financial products and services emerge in markets in response to a higher penury for financial services. Further, the Patricks hypothesis (1966) was introduced with the supply leading and expect following, which is important to determine the relationship between financial development and economic growth. The demand following view explains the demand for financial services as dependent upon the growth of real output and the modernization of subsistence sectors. Thus, the creation of modern financial institutions, their financial assets and liabilities, related to financial services are a response to the demand for these services by investors and savers in the real economy. Therefore, the more rapid growth of real national income, the greater will be the demand by enterprises for external funds (the savings of others) and therefore financial intermediation. Also, with a given aggregate growth rate, the greater the variance in the growth rates among different sectors or industries, the greater will be the need for financial intermediation to transfer saving from slow-growing industries to fast-growing industries. In this case, an expansion of the financial system is induced because of real economic growth.The second causal relationship between financial development and economic growth is termed the supply leading by Pa trick (1966). Supply leading has two functions. Firstly, is to transfer resources from the traditional low-growth sector to the modern high-growth sector and secondly, to promote and stimulate an entrepreneurial response in these modern sectors.Thus, the availability of financial services stimulates the demand for these services by the entrepreneurs in the modern, growth-inducing sectors.However, previous empirical studies have produced mixed and conflicting results on the nature and direction of the causal relationship between finance and economic growth