In the previous note on the lecture series of financial institutions and markets, we learned about the financial system that is broadly classified into the financial markets and financial institutions. We have covered how the supply and demand of funds affect the financial market and why financial market equilibrium is required. Further, we have also seen why the financial market should be efficient and market efficiency measures. Furthermore, we have also covered how financial development can be measured with the help of different financial development indicators. This note will learn and understand the relationship between financial development and economic growth as a whole for a nation.
Important of Financial Development for Economic Growth
Materials and money are crucial inputs in production activities in the economy.
Financial development can affect the growth process through the changes in the savings and investments behavior. It means financial development provides savings. That saving is automatically invested in the market whether the investment is made in the financial or physical assets or any other kind of assets that the consumer uses for different reasons. So, once the savings and investments get affected automatically, it will impact the various investment processes and, consequently, will impact the growth process.
Financial development also enhances the efficiency of the medium of exchange function. For example, how fast can the money be transacted, like a credit card, debit card, money transfer from one account to another, UPI? These types of transactions show the efficiency of the function of the medium of exchange. So, once the efficiency of the medium of exchange changes, the trading activities get affected. The transaction activities get involved, then automatically, it will impact the growth process.
Savings and investment are the central factors contributing to the economic growth process. So, the three critical parameters are financial development, savings and investment, and economic growth.
The below section will see different theories that link financial development with savings and investment.
Therioes of the Impact of Financial Development on Savings and Investment
- The Classical Prior Voluntary Saving Theory
- Credit Creation Theory
- Forced Saving or Inflationary Financing Theory
- Financial Repression Theory
- Financial Liberalisation Theory
Prior Savings Theory
The overall gist of the prior savings theory is that the investment is a function of the savings, and savings affects the investment. In the below section, we will discuss the prior savings theory with examples.
Classical economists give prior savings theory, which tells that saving is a prerequisite or determinant of investment. Here savings represent surplus money saved by an individual. The surplus money is calculated as subtraction of total income from consumption. On the other hand, inflation is opposed to savings, and it advocates control of inflation.
In the system, more inflation will have an adverse impact on everything. So, savings advocate the control of inflation or any kind of policy.
It also suggested, the real interest rate should always be high and positive. The high-interest rate encourages the savers to make more savings. As we know, if the interest rate is more, it will have an impact upon the supply side in a positive way because more people will be interested in depositing their money in the banks. However, on the other side, banks will charge a very high-interest rate on the borrowers, or the lending rate will be higher. Consequently, investment gets affected as demand for money will go down because of a higher interest rate.
Real Interest Rate is defined as subtraction of Nominal Interest Rate with Inflation Rate. So the real interest rate affects the savings behavior.
Moreover, the entire savings theory goes like that, once the public’s savings come to the banks, it goes to the market, and investment automatically occurs.
This theory tries to analyze what kind of services these financial institutions offer in terms of the different aspects and how they contribute to the growth process through savings and investment behavior. These are as follows:
Liability-Asset Transformation
It can be easily understood with an example. Whenever we deposit money in the bank, it is an asset for us as we get returns from the bank. However, it becomes a liability for the bank because it needs to pay interest to us. But still, take money because they create assets by providing loans to the individual or investors. Whoever has taken a loan will pay interest to the bank, and finally, the bank will return some percentage of the interest amount to the depositors. It is a way, assets and liability are transformed.
There is a transformation happening with one stakeholder; it is considered an asset; it becomes a liability with another stakeholder. In the next period, these things converted from liability to assets. And this transformation can only be done by financial institutions. So the entire process, contributes to the growth process.
Size-Transformation
Financial institutions, specifically banks, are responsible for the circulation of money to a large extent in the financial system (nationwide). For example, people generally deposit their savings to a bank account, and the individual savings amount is very negligible. However, as an aggregation, these small amounts will become huge. This huge amount of money can be transformed into a considerable loan amount for lending purposes. In this way, we can see that the size transformation is done by the financial sector only.
Risk-Transformation
Financial institutions, specifically banks, are responsible for the circulation of money, and as a return, they pay interest to the depositor. So, it is a bank’s responsibility to manage all kinds of risk and pay interest to the individual without transferring risk to the individual. These risks can be managed in various ways, like diversified, hedging, and risk transfer.
Whenever we talk about hedging, we take the help of derivative instruments and take positions into these. If one market does well, another market may fall; if one market fails, another market goes up, and so on. So, whatever loss we are making in one market can be gained in another market because we are taking a reverse position. Thus, through hedging, we minimize the risks.
Diversification means we are holding so many assets that if one or two fail and the other goes up, these do not impact the overall investment amount. These assets may be stocks, bonds, bank deposits, derivative instruments, and other instruments. So in that context, if we take a position in the different markets, risk can be quickly diversified or reduced.
Transformation by the insurance policies, maybe everybody is paying the insurance premium, but everybody may not use it. So, the individual premiums can be utilized to pay the bill for specific individuals based on the insurance claims. Thus, it is another way to risk transformation.
Maturity Transformation
The individuals are depositing money for a certain period but not more than five years or more on average. However, banks can easily provide long terms loans. For example, housing loans for twenty years. It is a perfect example of maturity transformation as an individual can not keep the money for a longer duration, but banks can still manage or provide long-term loans to the needy.
Credit Creation Theory
The financial system plays a positive and catalytic role by providing finance or credit through the creation of credit in anticipation of savings. It means the financial system can also create credit in anticipation of savings.
For example, a bank can create credit more than their deposits. It is because the bank can create the deposits of the savings as of their economies of scale and economies of scope.
- Economies of scale mean that this particular organization exists on a larger scale.
- Economies of scope mean they are providing a different kinds of services by that somewhere they can manage the risk in such as way that the total risk of that particular system can be minimized.
The independence of investment from saving in a given period. However, it may not always be possible; investment can’t be possible unless there are savings. The equality in savings and investment is a question mark that always savings may not be equal to the investment; that is, savings may be lesser than investments, and that is possible because credit creation is possible in this case as the bank can create money. The investment out of created credit results in a prompt income generation. Once the credit is created and goes to the market for investment—obviously, the production increases, leading to more income for the economy at large.
Credit creation does not subscribe to the concept that savings are the only factor that affects investment. Moreover, without savings, investment can also be possible by creating credit. Once the credit is created, it can generate a certain kind of income because of the productive usage of that particular credit in the system.
Theory of Forced Savings
It is believed that inflation is required for the development of a particular system, and savings do not determine investment. However, savings may be determined by the investment. It can be understood with an example: Suppose the policymakers can take certain policies so that the investment can grow. Accordingly, total profit in the system will increase, leading to more corporate savings. Thus, this theory does not subscribe that savings always determine investment.
The investment can change autonomously through monetary expansion. It means the money supply can be determined by the regulators or the monetary authority exogenously outside the system. If the money supply increases, it will have a positive impact because the output will go up when the investment goes up. Subsequently, income will go up, and obviously, corporate savings will go up. Thus, exogenously changing the money supply impacts the investment behavior at large, and finally, the savings also get affected.
Monetary expansion affects the economic growth process. According to Keynes, the particular economy is not always at the full employment level; there are some available and unemployed resources. If the money is supplied above the capacity of the economy and capacity is underutilized, then it will increase the demand because still, the resources are unutilized. When the investment rises, demand rises, and as a result, production increases, output increases, and total corporate savings increase.
When money comes to the market, investment increases, and if resources are underutilized, then demand increases, production and consumption increase. As a result, corporate income and savings increase. So, in this context, if that happens, it will not lead to inflation as there were some unemployed resources. However, the reverse is not valid.
There is another condition when the resources are fully employed in the system. It means the capacity is not there; whatever resources exist in the system that is completely employed. According to Tobin, the portfolio shifts effect can be seen as well as it creates inflation when money supply occurs. Therefore, the real interest rate from the financial sector will go down. But people have the money as money is available in the system. They will shift to spend their money in the physical sectors or physical goods, expecting inflation to increase. As a result, demand increases, inflation rate increases. If this cycle continues, production and consumption increases lead to the growth process.
Income distribution effect: Income comes from the financial sector to the physical sector. Once the physical goods sector goes up, there is an income redistribution between these two sectors. It means the physical sector increases the savings or, in other words, producers make profits; as a result, corporate saving increases. Once corporate saving increases, money again comes to the market in investment. Finally, the growth process can take place. The entire process is called Portfolio Shift Effect, as the money or investment from the financial sector to the real sector or physical sector.
Inflation Tax Effect: Once the profit increases, they will pay more tax, which will increase revenue for the government. And the government will use tax revenue for public expenditure. It is called the inflation tax.
When inflation increases, government revenue also increases. Because inflation is already a little bit higher, the product’s price is a little higher, then the profit level of the producer will be more than once the profit is more they will pay more tax and this is the way government revenue from tax increases. And finally, the total growth process increases as the government is getting more money for the growth and development of resources as a whole.
In this process, there are different channels through which monetary expansion can affect the growth process at large.
Financial Regulation Theory
The financial regulation theory states that everything should not be market-determined and government intervention is very much required. As some economists have argued, the financial markets are prone to market failure, so government intervention is necessary to control that.
Lowering interest rates through government intervention improves the average quality of the pool of loan applications and improve the efficiency with which the capital is allocated.
Direct credit programs can encourage lending to sectors that are usually shown by the market. If the government does not intervene, then the private sector lending such as the agricultural sector or small-scale industries will not be there because of a shortage of corporate loans from financial institutions such as commercial banks. As a result, the healthy development of the system may not be possible for the welfare of the society at large and ultimately affect the growth process in the economy. So some regulations are required in the financial sector by the government.
Government intervention provides that everything is a public good. Here, the public good is an instrument that is coming to the market that everybody can utilize. So if everything is market-determined, then only those industries will get investment where demands are more. But effectively, that will create an imbalance in the market because of the disproportionate of business industries within a nation.
Financial Liberalisation Theory
It believes that government intervention is not required because everything should be adjusted in terms of the market forces, both demand, and supply. To increase the interest rate on various financial assets as they would adjust to their competitive free market equilibrium.
An increase in savings financial liberalization leads to an increase in savings, a reduction in the holding of the real assets, and an increase in the financial deepening. It means the financial growth and development in different instruments and operations can grow up. So, liberalization can bring all kinds of efficiency to the market to a larger extent; everybody believes that the market should be fully liberalized.
Expansion in the supply of the credit because it is integrated and the market mechanism takes care of everything. There is a possibility that the supply of credit can grow up from different sources. It helps increase investment. Once investment grows up because of more participation and more instruments, more types of instruments and different types of investors such as FII, FDI, etc. When all kinds of investors are there in the system, it will increase the efficiency of the market. And finally, the investment grows up and increases in average productivity. As a result, the marginal efficiency of the capital spent on that particular market can go up, leading to more competitiveness in the market.
When more participants are there, then the market dynamics can not be manipulated, and market equilibrium can be achieved without the intervention of government bodies.
References
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