Norton Media Library
Chapter 13
Financial
Policy
Dwight H. Perkins
Steven Radelet
David L. Lindauer
Chapter 13 Outline
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1.The Function of a Financial System
Money and the Money Supply
Financial Intermediation
Transformation and Distribution of Risk
Stabilization
2.Inflation and Savings Mobilization
Inflation Episodes
Forced Mobilization of Savings
Inflation as a Stimulus to Investment
Inflation and Interest Rates
3.Interest Rates and Saving Decisions
4.Financial Development
Shallow Finance and Deep Finance
Shallow Financial Strategy
Deep Financial Strategy
Panic, Moral Hazard, and Financial Collapse
Informal Credit Markets
5.Monetary Policy and Price Stability
Monetary Policy and Exchange-Rate Regimes
Sources of Inflation
Controlling Inflation through Monetary Policy
Reserve Requirements
Credit Ceilings
Financial Policy: Introduction
• Financial policy deals with all measures intended to affect
growth, efficiency and use of diversified financial system
to meet it objective. It is also called Monetary Policy
• There are 4 basic functions of a financial system:
• 1. medium of exchange, &store of value,
• 2.Moblize savings from various sources and channel it to
investment-financial intermediation.
• 3. Transfers and distributes risk across the across the
economies
• 4. serves as policy instruments of stabilization
Functions of Financial System
• 1. Medium of exchange: Money supply
• Transfer deposits, checking & demand deposits,
time deposits,
• Money Supply: M1= narrow money (C +D)
• Broad Money M2= includes time deposits (T)
• Broadest Money=M3 includes liabilites of
specialized institutions
• Summary: M1=C+D, M2= M1 +T, M3 =M2+ O
Concepts of Macro-finance
• Financial ratio= financial assets/GDP
• Financial Intermediation: Measure by flow
of funds-accounts or liquid/Asset Ratio
• Risk Transformation and distribution: A
perfectly working Financial system will
reduce risk with exception of disasters.
• Stabilization function- to control inflation
and recession
Inflation and Saving Mobilization
• 1. Prevent severe inflation and deflation or
hyperinflation such as Zimbabwe.
• Moderate inflation rate should be within the range
of 8 to 12%
• Inflation episodes (see table 13.2 for history of
inflation in various countries)
• Inflation in major regions of the world including
global inflation ( see table 13.1)
• Case study: Hyper-inflation in Peru: 1988-90
Saving Mobilization cont.
• 1. Forced mobilization of savings – reduce money
supply: Germany 1922-23, Peru 1988-90
• 2. Inflation as a stimulus to investment. Inflation
of about 10% may be OK even helpful
• 3. Inflation and interest rates: Rate offered to on
deposits of savers in a bank- subject to control
• 4. Real interest rate= nominal rate adjusted for
inflation: real rate (r )= (1+i)/(1+P)-1
• Example: In Malaysia: i=7% inflation was 5% so
the real rate is 7%-5%= 2% (1992)
Financial Development
• Deep Finance: Promotes growth in the real
size of the economic system. Growth of
financial system is greater than income
growth
• Shallow Finance : Ratio of liquid assets to
GDP grows slowly on not at all or falls
Financial Strategy
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Shallow Finance Strategy: high reserve requirements on commercial banks,
non-price credit rationing , negative interest rate
Deep Finance Strategy: Mobilies larger volume of savings for domestic
economy , enhance fund accessibility, secure efficient allocation of savings,
permit financial process that requires positive real rates solved by rasing
nominal rate to curb inflation,
Finance, Moral Hazard and Financial collapse: Rapid withdrawal of funds and
panic some what like now but classic case of 1995 Pesso Crisis in Mexico, or
financial crisis of East Asia in mid 1990s..
Moral Hazard: An effort to protect people and institutions from risky behavior
actually leads people to take more risky activities.
What is needed is prudential regulation
Informal Credits; Many in Africa- Like the money lender
See Case of Credit and Saving Inflation: Bangladesh and Indonesia
Grameen Bank found by Mohammad Yunus is a classic case. Imposes social
descipline
Monetary Policy and Price Stability
• Monetary Policy Exchange Rate Regimes
• Fixed, pegged, managed, flexible ( see figure 13.1
for prototypes)
• Sources of Inflation: Money Supply
• M=DC +IR= Domestic stock+ Intern. Reserves
• Change in M= change in DC = change IR
• Government can only control DC not much
control IR
Strategies of Controlling inflation
• 1. Open market operations: direct control on reserves by
central banks
• 2. Increase legal reserve requirements of bank reserves
• 3. Increase discount rates so commercial banks can borrow
less.
• 4. Moral suasion: Exhortation of monetary officials
• 5. Credit ceiling imposed by Central Banl
• 6. Adjustment in allowable nominal rates on deposits and
loans
Chapter13 : Financial Policy
Learning Objectives
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The functions and characteristics of the financial systems in
developing countries.
The definition of money and liquid assets.
The diversity of inflation experience in developing countries and the
pros and cons of using inflation as a device to mobilize forced
savings.
How inflation affects real interest rates and how real interest rates,
in turn, affect savings and the demand for liquid assets.
The characteristics, causes, and consequences of deep finance
versus shallow finance.
The character of informal credit markets in developing countries.
How management of monetary policy depends on the exchange-rate
regime.
The causes and consequences of excessive money supply growth.
The main tools of monetary policy in developing countries.
The causes and consequences of financial panics.
Chapter 13: Summary
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CHAPTER OUTLINE
I. Financial policy in developing countries encompasses all measures intended to
influence the size, structure, and operation of financial markets and the system of
financial intermediaries. The financial system plays a key role in development by
supplying financial assets (including money, variously defined), by mobilizing and
allocating savings (financial intermediation), by distributing risk, and by providing
monetary authorities with tools for managing economic stability. The ratio of broad
money (M2) to GDP is a common measure of financial development.
2 The most obvious problem of financial policy in developing countries has been
controlling inflation. The text distinguishes among chronic, acute, and runaway
(hyper-) inflation, and then reviews the sad history of high-inflation episodes over
the past half century. Usually, the source of inflation can be traced to
unmanageable government budget deficits.
3. Some economists argue that moderate inflation can be beneficial, as it forces the
mobilization of savings by effectively taxing money balances. Some also contend that
inflation may be tolerable as a by-product of keeping aggregate demand buoyant to
stimulate investment. Yet, high inflation may have the opposite effects. First, the
inflation tax augments domestic savings only if the government has a higher
marginal propensity to save than the private sector, which is improbable. In any
case, inflation is a very distortionary form of tax. Second, high inflation often is
associated with negative real interest rates. While the link between interest rates and
savings is weak, there is no doubt that negative real interest rates strongly affect the
form in which savings are held. In particular, negative real interest rates reduce the
demand for liquid assets; this impedes monetization and financial intermediation. In
Chapter 13: Summary cont.
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4. Indeed, negative real interest rates is a hallmark of a shallow financial system.
Shallow finance results from policies involving repressive interventions, which
retard development of the financial system. In contrast, deep finance can be
achieved by liberalizing financial markets and avoiding sharply negative real
interest rates and rapid inflation. A deep finance strategy puts the financial system
to work mobilizing and allocating savings. It also accelerates the development and
efficiency of the financial system and helps reduce dependence on informal credit
markets.
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5. The final section examines the relationship between monetary policy and inflation.
From the balance sheet for the banking system, one can derive the fact that money
supply growth is determined by the expansion of domestic credit and changes in
international reserves: ∆M =∫ ∆DC + ∆IR. This shows that money supply expansion,
and thus inflation, is linked to credit expansion for financing government deficits and
private investments and to the balance of payments. The second term on the right-hand
side of this identity implies that monetary policy is affected by the choice of exchangerate regime. In a small, open economy with a fixed exchange rate, the monetary
authority must buy and sell international reserves to stabilize the foreign exchange
market; but this means that it cannot independently control the money supply. Similarly,
the need to finance large fiscal deficits may cause the central bank to lose control of
money supply growth. To the extent that monetary authorities have an independent
role in stabilization policy, they influence the volume and cost of credit by
determining reserve requirements and the rediscount rate, by managing credit
controls, and by using moral suasion to influence the banking system.
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This concludes the Norton Media Library
Slide Set for Chapter 13
Economics of
Development
SIXTH EDIT ION
By
Dwight H. Perkins
Steven Radelet
David L. Lindauer