The Structure and Role of the Financial System - Essay Example

? Question Introduction This paper will seek to explore between the real economies, which include the tangibles jobs, goods, and services, and the intangibles, which include money, interest rates, and the stock market. In order to discuss the link between the financial system and the real economy, the paper will first discuss the structure and role of the financial system and then later the link between the two. The real economy consists of households, firms, and other agencies involved in the production of goods and services. These factors can be consumed in the present time or utilized with an aim of producing in the future. Economic activity is taken as real because real resources are utilized to come up with new products that can be bought and used. On the other hand, the financial system mainly focuses on either circulating funds around to enable people buy goods and services or assist people exchange ownership of resources vital for production purposes. It is worth mentioning that activities of the real economy are vital for human survival. The real economy is responsible for the production of consumer goods, food, lighting, heating, and entertainment to mention but a few (Mankiw 2008, p.162). The role of the financial system is to facilitate the production of such goods by ensuring that funds are available when needed. Therefore, the structure of the financial system comes to the fore since it would offer alternative financing windows. These institutions provide an avenue through which large or small manufacturing sectors can access finance, which would boost production. The role undertaken by the financial system in coordinating economic activities, which includes the cost of finance, profitable investment outlets, and availability of investment funds, has a direct relationship with the structure of the financial system. Technology and peoples’ skills must be sufficient in line with the level of development of the financial system in order to offer the required support in the real sector. However, a consensus is yet to be reached on whether there is anything real between the real and financial sectors. In addition, there is still a dilemma on whether the relationship is unidirectional, which implies that it is either flowing from the financial sector to the real sector or whether it is bi-directional. However, it appears that most economists are in agreement that a link exists between the financial system and the real economy (Burton & Brown 2009, p317). The structure and role of the financial system The financial system is made of financial institutions and financial markets. Examples of the financial institutions include the banking system (banking institutions and the central bank), and non-bank financial institutions (insurance and pension funds). The financial markets are made of foreign exchange markets and money markets, capital markets, which include bond markets, private debt securities, public debt securities, and equity markets, and the derivatives markets. The current literature work has not fully addressed the issue of the role and structure of the financial system essential in facilitating and sustaining growth. There are two general agreements in relation to the role and structure of financial systems; first, countries with good working banks and financial markets can increase their growth pace. Secondly, better functioning financial systems reduce the burden on external financing, which hinder firm and industrial expansion (Mordi 2010, p.8). Role played by the financial sector in the economy A crucial role that the financial sector plays within an economy in the facilitation of growth is the reduction of enforcement, information, and transaction costs. This function is achieved through a number of unique functions performed by the financial sector. Therefore, the financial sector has some basic functions that include provision of efficient modes of payment for the whole economy, and intermediary between lenders and borrowers. The mentioned basic functions form the domain of the banking institutions. Banks in conjunction with other financial institutions play a vital role in running the economy through funding. A major role of banks is that they are the main suppliers of credit to investments that generate finance and other debt-financed activities (Burton & Brown 2009, p. 321). Secondly, the banking system performs the vital role of channeling resources from savings to investment. Thirdly, one notable issue is that greater financing of savings have a greater potential to channel savings to productive activities. In addition, an efficient system allows for better mobilization of resources. The financial intermediaries have some basic functions that have a direct impact on the real economy. The five basic functions include; first, the mobilization and pooling of savings. With good measures in place, mobilization of savings enhances technological innovation and resource allocation. In line with this fact, effective financial systems are vital in promoting economic development through an increase of savings (Mankiw 2008, p165). The second function of intermediaries is the production of information related to possible investments and allocation of capital. In this case, people suffer high costs in their attempts to acquire and process information on firms, market conditions, and managers. Lack of this information could hinder capital from flowing to its maximum potential. Financial intermediaries help in reducing the cost of acquiring information through specialization and economies of scale. This boosts resource allocation and growth pace. The third function is in the monitoring of investments and exerting corporate governance. With good governance, there is improved efficiency with which firms utilize and allocate resources. In addition, good corporate governance motivates savers to become more willing in financing production and innovation (Mankiw 2008, p.166). Ways through which corporate governance can be strengthened include monitoring and disciplined creditors, activism from shareholders, which is exercised by institutional investors, threats of takeover and market for corporate control, threats from insolvency, and capital market competition. The fourth function is the facilitation of trading, diversification, and risk management. Financial systems help in controlling risks associated with individual countries, industries, projects, regions, and firms. It is worth noting that the ability of a firm to offer risk diversification services goes a long way to impact on long-run economic growth. This is because there are improvements on resource allocation and encouragements on those who save to do more savings. Apart from these roles, financial systems are responsible for the enhancement of liquidity, reducing liquidity risks, increased investment in long-term as well as promoting economic growth (Mordi 2010, p.9). The fifth function played by financial intermediaries is the facilitation of exchange of goods and services. Financial systems facilitate transactions within an economy by providing and improving payment systems. In addition, the financial systems help in the reduction of transaction and information costs related to financial transactions. In such circumstances, specialization in production is highly recommended, there is an enhancement in technological innovation, and finally, growth is achieved. Impacts of backward linkage arise from the mentioned productivity gains, which contribute to financial market development. Therefore, economic development can easily boost the development of the financial sector (Mordi 2010, p.9). Financial sector and the real economy The link between the financial sector and the real economy can be best understood through monetary policy perspective and intermediation role of financial institutions. Over a prolonged period, economists have been of the opinion that financial markets and institutions are vital elements in supporting economic development. Economists such as Fry, Shaw, McKinnon, and Goldsmith have pointed out a strong positive link between the development of financial markets, and the speed of economic growth. In addition, they have pointed out a negative relationship between financial repression and growth. It is worth mentioning that the literature provided by these economists has not managed to offer theoretical linkage between financial development and growth (Mordi 2010, p.10). In the recent past, numerous economists have come up with a model that brings out a formal link between financial intermediation and growth. In this scholarly work, two issues are taken considered. The first issue includes the analysis of how financial intermediation influences economic growth. Secondly, it analyses how economic growth might have an impact on the evolution and growth of financial intermediation. There are economists who agree that financial intermediaries promote economic efficiency and growth by offering assistance in allocating capital to its best use. Several studies support that financial development offers a positive impact on economic growth. Further studies support that, in the short-run, there tends to be linkages between economic growth and financial development within high income OECD countries. However, in South Asian and Sub-Saharan countries, the situation is different. For this reason, a different approach was adopted to bring a steady economic growth across all geographic regions and income groups (Burton & Brown 2009, p.325). One of the interpretations provided by economists is that high financial development boosts growth or increased growth results to highly-developed financial systems. Therefore, one of the conclusions that can be made is that financial development is a vital determinant of economic development. Majority of the economists are of the opinion that economic development does not only come from financial development, but also economic growth boosts the incentive for financial development. In the same note, efficient financial systems assist countries to grow through the mobilization of additional financial resources and also through the allocation of resources for maximum utilization. Economists note that financial sectors become growth supportive when financial institutions are run under proper governance structures (Mordi 2010, p.12). Development of the economy goes hand in hand with the development of financial systems that serve such economies. With continued financial system growth, effective channeling of finances reduces both the transfer costs and risk taking from savers to borrowers. With good financial intermediaries in place, there is better allocation of resources within an economy, which goes further to stimulate capital accumulation and growth. However, with increased economic growth, there is increased participation of investors within the financial market. One notable issue is that financial intermediaries bring better allocation of savings to investment, boost the rate of capital accumulation, as well as an increased rate of economic growth (Mankiw 2008, p171). There is an interrelationship between financial sector development and economic development. For this reason, there is no any economy that can grow and transform the living standards of its people without a well-functioning and efficient financial sector. Having this in mind, a sound and healthy banking system has a direct relationship to economic growth and development. The modern growth theory offers two main avenues through which the financial sector might have an impact on the long-run growth in a country. This is achieved through speeding up capital accumulation including human and physical capital and also through increased rate of technological progress. The five basic functions of a financial sector that works effectively enable the mentioned avenues to work for the purpose of promoting growth (Mordi 2010, p.13). The promotion of economic growth arises through mobilization of savings for investment, facilitation and encouragement of capital inflows, and efficient allocation of capital among competing uses. Channels of monetary policy transmission mechanism Monetary policy refers to measures that monetary authorities undertake to impact on the amount of money or interest rate with an aim of achieving stable prices, economic growth, and full employment. Since monetary policy initiatives function through financial markets, the way through which this happens offers another link between the financial sector and the real economy. The central banks have a role in influencing the amount of money and interest rates with an aim of achieving price stability, economic growth, and full employment. Therefore, for this to happen, there must be some link between financial variables and macroeconomics variables. These links include the monetary transmission mechanism, which refers to the way dynamics in the financial sector affects the real economy (Mordi 2010, p.15). Conclusion Linkage is a two way thing from the financial to the real sector and vice versa. The impact of the financial sector in the growth of the economy depends on the central role it plays in the mobilization of savings and effective allocation of resources for maximum utilization, as well as investing in the real sector. It is crucial to note that the behavior of the financial sector has a direct impact on the behavior of the real economy. The real economy brings about financial activity through employment of people (focused in saving a portion of their income) in firms, which are focused on borrowing in order to invest. There is a long history on the link between the financial sector and the real economy. Empirical research suggests that there is a positive relationship between the two. The linkage between the two becomes evident in times of an economic crisis. This was evident during the recent economic crises. Therefore, the real economy and the financial sector have a relevant link both in times of crisis and stability. References List Burton, M. & Brown, B. (2009). The Financial System and the Economy: Principles of Money and Banking, New York, M.E. Sharpe. Pp. 317-326. Mankiw, N. G. (2008). Brief Principles of Macroeconomics, London, Cengage Learning. pp. 162-172. Mordi, C. N. (2010). The link between the Financial (Banking) Sector and the Real Economy, Economic and Financial Review, 48 (4). pp. 8-15. Read More