Role of Financial System in an Economy

Role of Financial System in an Economy

A financial system in an economy is a set of institutions such as banks, insurance companies, stock exchange, etc. that render a prominent role in an economy. The functioning of the financial system has multifaceted effects on the economy. The central bank of the country has the authority to shape, control and monitor the financial system in order to achieve its macroeconomic goals. The financial system of a country comprises of following components.

  • Money – money is the beginning of the financial system and used for exchange purposes.
  • Financial instruments – stocks, bonds, mortgages, and insurance, etc.
  • Financial Markets. Capital Market, Money Market, Foreign Exchange Market, etc.
  • Financial institutions – Banks, Insurance companies, etc.
  • Regulatory Agencies
  • Central Bank

There are two ways that the functioning of monetary forces affects the economic activities.

  1. Factors that affect the demand for and supply of money. This will determine the general price level and the inflationary factor of the economy.
  2. The effects of disequilibrium in financial markets. – How money and monetary policy affect aggregate demand and supply. Monetary equilibrium occurs when the demand for money equals the supply of money.

The financial system of a country is the main controlling device of macroeconomic performance. By making adjustments to the existing financial system, the authorities can drive the economy towards the desired economic goals. Thus, the role of the financial system permeates the following areas.

  • Economic growth and development
  • Investment
  • Saving
  • Capital formation for the businesses
  • Foreign exchange market
  • Development of infer-structure
  • Development of trade
  • Employment growth
  • Financial discipline and control of the country

Economic growth or the increase in national output is one of the key factors of economic development. An increase in the national output depends on the level of investment, the investment environment of the economy, and the availability of funds for investment.  The main source of funds for investment is the banks and other non-banking financial institutions such as insurance and other leasing companies, etc.

The role of financial institutions is to canalize the funds collected as savings of the general public.  The level of savings and investments depends on the rate of interest in the economy. The lower the rate of interest, the higher will be the demand for investment funds. The reason is that the low rate of interest reduces the cost of investment. Contrary, the low rate of interest discourages savings because it reduces the interest income of the depositors. The central bank has to decide the rate of interest in order to maintain a balance of both.

Every business requires capital and it takes mainly two types.

  1. Fixed capital – This is the capital in the form of fixed capital such as machinery and equipment, land, vehicles, etc. these are comparatively expensive and the industrialist has to seek the assistance of financial institutions.
  2. Working capital  –  This constitutes the re-current expenditure in the form of salaries and wages, electricity, etc. which the firms have to raise funds from financial institutions.

An efficient financial system is vital in dynamic macroeconomic performance. The key factor that determines the macroeconomic efficiency is the level of national output or the GDP. The size of the GDP depends on the efficiency of the financial system of the economy.

Investment and savings

Investment is the key factor in an economy that decides the level of output. Almost all modern industrialists obtain funds from commercial banks and other non-banking financial institutions, in addition to their own capital. Availability of financial institutions and credit schemes are the main motivating factor of investment. The ability of financial institutions to provide credit depends on the level of savings in the economy.

Accumulation of savings builds up funds in the financial institutions which can be used for providing credit facilities for investments as well as consumption purposes. Both production and consumption are dynamic macroeconomic factors that affect the aggregate demand and aggregate supply in an economy.

Based on the funds collected as savings, the commercial banks have the ability to provide credit more than the available funds which are termed as “credit creation”. Interest is the key motivating factor of both investment and saving in an economy. The financial authority utilizes the rate of interest as one of the controlling tools of the economy.

Growth of Capital Market

All businesses require two types of capital, namely the fixed capital and working capital. Mostly the fixed capital is raised by issuing financial instruments such as debentures, shares, etc. to the capital market. Public and other financial institutions invest in them in order to get a good return with minimal risk.

It is the practice of the businesses to find necessary funds for working capital from the money market where short-term funds can be raised through the issue of various credit instruments such as bills, promissory notes, etc.

Foreign Exchange Market

The foreign exchange market enables state and central government and large-scale businesses to raise short-term and long-term funds through the issue of bills and bonds. These carry alternative rates of interest along with tax concessions.

It’s clear that the Capital market, Money market, and Foreign exchange market enable the industrialists and the governments to meet their capital requirements. In this way, the development of the economy is ensured by the financial system of a country.

Development of Trade

The financial system of a country helps in the promotion of both domestic and foreign trade. The financial institutions finance the traders directly and the financial markets help in discounting financial instruments such as bills of exchange. In additio0n, the commercial banks provide pre-shipment and post-shipment finance to those who are in the trade. Issuing Letters of Credit in favor of the importers is another support extended by the commercial banks. Thus, due to the presence of an efficient financial system, the country can earn much-needed foreign exchange.

Providing some of the capital goods on hire purchase and installment basis, helping in employment growth, infrastructure development are some of the other advantages that a country can gain through an efficient financial system.

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