Question

This unit discusses money, its meaning, its value and its role in the economy now and over time. The unit concludes with a discussion of the open economy. Learning Objectives: Identify and describe the major components of the financial system and explain the role of money in a market economy. Discuss the concept of an open economy and explain the calculation of the balance of trade. Explain the major determinants of foreign exchange rates and discuss the factors that cause a currency to appreciate or depreciate.

Answer 1

A financial system is a system which enables borrowing and lending. The basic components of a financial system can be classified as a) Financial institutions, b) Financial markets, c) Financial instruments d) Financial services.

a) Financial institutions.

Financial institutions give a platform for the meeting between lenders and borrowers. These institutions collect the savings of the people and making it available to the borrowers.

The financial institutions are regulatory authorities like central bank, and banking intermediaries like commercial banks and non banking financial intermediaries insurance companies, mutual savings banks etc.

b) Financial market.

Financial market is the market where short term as well as long term securities such as shares, bonds and debentures etc dealt with. It consists of issuing company, investment banks, brokers, agents and investors. The financial market is divided into primary market and secondary market. The primary market is a place where new financial securities are issued. But in secondary market already issued securities are bought and sold.

c) Financial instruments

The financial instruments have a major role in a financial market. This facilitate for the collection of capital for the companies. The equity shares, bonds, debentures, treasury bills and certificate of deposits are the major financial instruments in a financial market.

d) Financial services.

Yet another component of a financial market is financial services. The financial services include the services of banks, nonbanking financial institutions, investment banks, pension fund, mutual funds and the services of underwriters.

Role of money in a market economy.

1. Facilitate capital accumulation.

The role of money is so significant in a market economy. Capital accumulation is the prime feature of a market economy. The large scale of capital accumulation is possible only with the help of money in a market economy.

2. Price mechanism.

The market economy is based on price mechanism. The price mechanism can operate only with the help of money. The value of supply and demand is estimated in terms of money.

3. Freedom of enterprises.

The freedom of enterprise is a noted feature of a market economy. The entrepreneurs can accumulate capital only in the form of money. The entrepreneurs need to purchase factors and they need credit. All these cannot be done in the absence of money.

4. Consumer sovereignty.

Buying various commodities with money, the consumers can satisfy their satisfaction. The consumer’s utility and his welfare are measured in terms of money.

5. Profit motive.

Profit motive is the driving force of a market economy. For making profit, the cost, revenue, demand and supply etc to be calculated. In a market economy all these are expressed in terms of money.

6. Control the economic system.

In a market economy all activities like production, consumption, exchange and distribution etc are regulated only through money. Therefore money overall controls a market economy.

Open economy.

An open economy is one which has economic relation with the rest of the world. It allows the international flow of goods and services. All type of economic activities take place between the residents of a country and residents of other countries.

All countries having trade relations with the other countries, import some commodities and services and export certain other commodities and services. The difference between the value of export and import is known as the balance of trade(X-M). If a country has a trade deficit, its import will be more than its export and it is unfavorable to the growth of the country. If it has a trade surplus, its export will be greater than its import.

Determinants of foreign exchange rate.

1. Economic policy of the government like fiscal policy and monetary policy.

2. Balance of trade.

3. Inflation in the domestic market.

4. Economic growth.

Factors cause appreciation and depreciation of exchange rate.

1. Volume of trade- High volume of import cause depreciation of a national currency and high export cause appreciation of a national currency.

2. Capital movements- large outflow of capital from one country to other cause depreciation in exchange rate and large inflow of capital cause appreciation.

3. Speculation- Speculative activities cause fluctuation in exchange rate. An expectation of future fall in exchange rate cause depreciation in the value of currency and viceversa.

4. Monetary policy.- An expansionary monetary policy cause inflation domestically and result in more import and less export. The depreciate the external value of national currency.