Question

Many academics as well as global monetary institutions like IMF and BIS have concluded that when financial sector gets big, it starts hurting economic development. As finance starts having adverse effect the role of the capital markets and the banking sector in funding new investment is decreasing. Write a short essay (1-2 pages) about the role of financial sector, and start it with a personal view by highlighting the benefits/drawbacks that you’ve experienced. Then discuss positive and negative macroeconomic aspects that the financial innovation or too big financial sector can bring about. Evaluate the role of finance in modern society to conclude the essay.

Answer 1

Time and again it has been said that finance is crucial to the economy’s growth. The financial sector acts as an effective intermediary between various other economic entities like the households, the firms and the government. It channelizes the flow of money , held as deposits either in banks or in form of stock and shares in the capital market into areas that could reap returns to the owner of the funds. The sector acts as a facilitator and paves the way for the funds to flow from their owners—the households, the firms and the government --to areas where they are in demand, this function has proven to be so crucial aspect to achieve economy’s development that we cannot even think of a barter exchange economy today, especially the deferred payment or paying future , which is the most important aspect of finance today—we all love to invest now and seek its returns at a later stage!!

However , the risks involved in the investment process are manifold. The efficiency of capital to produce expected returns is not easy to be predict since it involves forecasting the future returns based on certain present calculations, a risky proposition since it means predicting the future based on the present!! This depends upon the interest rate which is the reward for capital, the interest rate would depend upon the demand for investments which again depends upon the returns of the investment—higher the return higher is the inducement on part of the investor to invest

The financial sector’s role is also limited by the banking habits of the people, If the population is withdrawing huge amounts of cash to purchase various goods and services, if the aggregate expenditure is high, then the amount of demand deposits with the banks might significantly reduce and thus the sector’s activities are greatly hampered, especially the banks, whose credit creation process is stalled. On the other hand if the aggregate supply is more than the aggregate demand , if people are saving more and spending less on consumption then even though funds are available investment would not really take off since the aggregate demand is low—hence the financial sector largely depends upon the investment climate in the economy.

Banks are only a part of the financial sector, since saving in banks is the most easiest and convenient form of indirect investment (since banks utilise those funds for generating investment and capital stock) much importance is given to commercial banks which also have diversified into investment banking and so on. This is however only a part of the major aspect of financial innovation. Just like how it is important for an entrepreneur to innovate and constantly capture the consumer’s attention so also the financial sector too has diversified and has created many other tools like mutual funds, traded funds, bonds, stock, equity and so on. It has also paved way for many agencies that are acting as intermediaries between the firms and the households in channelizing the funds towards high risk yet good returns options. These agencies have also given way and have created a market for newer careers like investment banker, financial analyst, financial consultant and so on.

The growth of financial sector has led to the efficient use of savings of the individuals, the corporates and the government. It has led to the acceleration of capital formation, an important criteria for economic development—the higher the capital stock , the more positive is the economy’s development, the higher is the GDP and the more consistent will be its long term growth. The impact of financial sector is very great and visible in the growth of industry and trade.

The financial sector is crucial for economic development since it provides finance for various development activities both in the private sector as well as in the public sector, even in case of priority sectors like small scale industries, start ups and agricultural sectors, financial innovation has brought positive changes as  is seen in industries of  these sectors have registered a faster growth pace .

Although, financial innovation and its importance cannot be challenged yet there are some subtle aspects that cannot be ignored. The growth of a firm depends more on the factors of production, the efficient combination of these inputs and the risk taking ability of the entrepreneur and not just finance alone.

                   The output depends upon the level of aggregate demand , higher the income(GDP) of a nation, lower will be the MPC or the marginal propensity to consume and higher will be the MPS or the marginal propensity to save, as savings is a positive function of income, since people would like to utilize their income for savings and investments expecting a higher returns, so while the financial sector grows, the gap between the aggregate demand and the aggregate supply will widen and this will lead to a surplus of goods –including inventory, which in fact induce firms to reduce production and will lead tom a fall in the demand for factors of production, the income flow declines.

   Hot money flows( flows of foreign investments towards that part of the world where the returns on investment is high and attractive) and other foreign investment flows which though are very essential for economic development yet will bring with them the financial roadblocks that are existing in other countries thus affecting the global financial sector’s health.

Thus , finance , the greatest tool ever discovered by man, is very much needed in today’s world for its sustenance. It is needed for all the basic economic activities—on which every economy system is based—consumption, production, exchange and distribution. It facilitates the growth of globalization, integrating the economies of the world closely. Financial sector has proven to be the closest link to show case the interdependence and the inherent interrelationships between the other sectors like households, firms and so on. The magnitude of the growth of this sector determines the growth of national income of an economy .It shows the macro economic equilibrium in an economy.