Chapter 5- The financial Sector

What are the functions of money?

Medium of exchange, Unit of account(provides a standard measure for pricing goods and services), Store of value(maintains value over time)

What are the characteristics of money?

Acceptable, divisible ,durable ,portable ,stable

What is narrow money?

Physical currency as well as money that individuals and business can withdraw at any time from the bank(current account)

What is broad money?

Includes narrow money as well as electronic bank deposits(entire money supply)

How is money created?

Printing physical money, creating bank deposits

By Commercial Banks – Through Credit Creation

This is how most money is created in modern economies.

🔁 Credit Creation Process:

1. You deposit money in a bank.

2. The bank keeps a fraction of it as reserves (e.g. 10%).

3. The bank lends out the rest.

4. That loan is spent, and the money ends up in another bank.

5. That bank repeats the process.

This is called fractional reserve banking.

What is the open market operations?

The buying and selling of government bonds in the open market to regulate the amount of money circulating in the economy

What is the Keynes liquidity preference theory?

Keynes argued that people prefer to hold their wealth in liquid form because it offers flexibility. Interest rate determination- the interest rate is determined by the supply and demand for money. The demand for money is inversely related to the interest rate.

What is the loanable funds theory?

The supply of loanable funds comes from savers(households, businesses) that deposit money into banks. This is positively related to the interest rate(as interest rates rise, savings become more attractive). The demand for loanable funds comes from borrowers who seek funds to invest in projects. This is inversely related to interest rates(when interest rates are high, borrowing becomes more expensive leading to a decrease in the amount of funds demanded)

What is the Fishers equations of exchange?

Shows the the direct link between money supply and inflation.M(money supply)xV(velocity of circulation)=P(Average price level-inflation)xQ(quantity of goods/services sold). MV-what is bought, PQ-what is sold

If the money supply increases while the velocity of money and the volume of transactions remain constant, the equation predicts that the price level (P) will increase, which leads to inflation. This is because there is more money available in the economy to chase the same amount of goods and services.

If the velocity of money increases, it means that money is being used more quickly in transactions, which could also lead to higher demand for goods and services, potentially raising the price level or output.

What are critics of the Fishers equation of exchange?

The fisher equation assumes that the velocity of money is constant but in the real world he velocity of money can fluctuate significantly due to changes in economic conditions.

What is the role of financial sector?

Facilitate savings(provides safe places for people and firms to save money), allocating capital efficiently(channels funds from savers to borrowers),providing liquidity(enables quick buying and selling of assets).

The financial sector connects savers and borrowers. It:

• Mobilizes savings.

• Provides capital for investment.

• Helps risk management via insurance and derivatives.

• Enables payments through banking systems.

What is the stock market?

The market for shares in companies.

What is the money market?

A sector of the financial market where short term borrowing and lending takes place. Short term loan finance(IOU<1 year)

What is the capital market?

Has the same purpose as the money market but it applies to medium and long-term finance such as stocks and bonds

What is the foreign exchange market?

Market for different currencies to be traded like pounds euros and US dollars

What is the Harrod-Domar Model

A model of economic growth that stresses the importance of a countrys savings and investment. Higher savings rate-more investment-faster growth

Formula for economic growth rate(Harrod-Domar model)

Savings ratio/capital-output ratio

Why is the Harrod-Domar model hard to implement?

• Assumes constant capital efficiency.

• Ignores other growth factors (like innovation or labor productivity).

• Overemphasis on savings — developing countries may face low incomes and struggle to save.

Even if an LDC is able to somehow increase its savings rate, why is there still no guarantee that capital accumulation and GDP growth will too occur?

savings dont always turn into productive investment, even when investment happens it may go into low productivity projects, lack of human capital

What is microfinance?

Microfinance refers to small-scale financial services provided to poor or low-income individuals who typically do not have access to traditional banking.

This includes:

• Microloans (very small loans)

• Savings accounts

• Insurance

• Payment systems

Purpose-To empower people to start or grow small businesses, increase income, and escape poverty.

What does Micro Credit entail?

advancing micro loans, at favourable rates of interest, to individuals that are unable to access finance in the formal financial sector.

What are the benefits of microcredit?

• Mobilizes savings into productive investments.

• Reduces poverty through microfinance and business growth.

• Promotes innovation by funding R&D.

What are some criticisms of microcredit?

Microloans are often small and costly to administer, so lenders charge high interest rates—sometimes over 30% annually.,

• Microcredit assumes loans are used to start or expand businesses.

• But in reality, many borrowers use them for consumption (e.g. food, weddings, school fees).

  Microcredit focuses on individual entrepreneurship, but poverty in LDCs is often due to big structural issues:

  • Poor infrastructure

  • Lack of education

  • Weak institutions

• Microcredit alone can’t solve these.

What are the issues with debt for developing and emerging economies?

decreased supply side investment, problems with additional borrowing, imprudent use of borrowing

What are some issues with debt cancellation as a policy?

Moral Hazard

• Definition: If individuals, firms, or countries expect their debts to be cancelled, they may be less likely to borrow responsibly in the future.

Reduced Lender Incentives

• If lenders (such as banks or international institutions) expect debts to be cancelled, they might:

  • Be more cautious in lending in the future.-may reduce investment

What are the core roles of a central bank like Bank of England?

Monetary policy implementation- adjust the base interest rate to control inflation, QE- buys financial assets to inject liquidity into the economy.

Lender of last resort

Regulating banks and financial institutions

Maintaining financial stability

What is the purpose of financial regulation?

Ensures financial stability ( prevents bank failures), protects consumers(stops exploitation), promotoes fair competition( prevents monopolistic behaviour), Prevents financial crime(tackles money laundering)

Why financial regulation matters?

prevents systematic risk-reduces the chance that the collapse of one institution will affect the whole conomy

reduces moral hazard- stops banks from taking excessive risk knowing they may get bailed out.

Protects consumers- ensures fair practices and transparent financial products

Drawbacks of financial regulation

Overregulation may limit banks ability to lend, slowing economic growth

Regulatory capture- when regulators become too close to the firms they monitor it reduces effectiveness

The role of the IMF in regulating the global financial system

promotes global financial stability, offers financial assitance to countries facing balance of payment crisis, provides surveillance- The IMF monitors the global economy, providing analysis and advice on economic trends, exchange rates, inflation, and fiscal policies.

The role of the world bank in regulating the global financial system

Focuses on long-term development and reducing poverty, provides loans and advice for infrastructure projects