Role of Financial System in Economic Development

Economic Development depends upon the financial system of a country, it is of immense use and plays a vital role in shaping the economic development for a nation. The volume and growth of the capital in the economy solely depends on the efficiency and intensity of the operations and activities carried out in the financial markets. An immature financial system hinders the growth of the economy and leads to the ruined economy, as the policies of the market are not clear to both the national and foreign investors thus ruining the development of the economy big time.

The major role of financial system can be explained by the following few key points:

  • Financial intermediaries enhance the investment in the economy, by the means of the direct and indirect investments
  • The process of transferring the monetary resources of the public into the financial resources by the financial intermediaries involves maturity inter-mediation, risk reduction through diversification, reducing costs of transaction and provides a payment mechanism, which in turn is the sole objective of the financial market.

Economic Development

Thus the financial market of a country forms one of the pillars of the economy, on which the success of the nation is dependent largely. The economic reforms and the growth of the individuals and the nation as a whole are highly interrelated to the working of the financial market.

The financial system comprises all financial markets, instruments and institutions. Today I would like to address the issue of whether the design of the financial system matters for economic growth. My view is that the answer to this question is yes. According to cross-country comparisons, individual country studies as well as industry and firm level analyses, a positive link exists between the sophistication of the financial system and economic growth. While some gaps remain, I would say that the financial system is vitally linked to economic performance. Nevertheless, economists still hold conflicting views regarding the underlying mechanisms that explain the positive relation between the degree of development of the financial system and economic development.

Some economists just do not believe that the finance-growth relationship is important. For instance, Robert Lucas asserted in 1988 that economists badly over-stress the role of financial factors in economic growth. Moreover, Joan Robertson declared in 1952 that “where enterprise leads, finance follows”. According to this view, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands.

Other economists strongly believe in the importance of the financial system for economic growth. They address the issue of what the optimal financial system should look like. Overall, the notion seems to develop that the optimal financial system, in combination with a well-developed legal system, should incorporate elements of both direct, market and indirect, bank-based finance. A well-developed financial system should improve the efficiency of financing decisions, favoring a better allocation of resources and thereby economic growth.The financial system is also particularly important in reallocating capital and thus providing the basis for the continuous restructuring of the economy that is needed to support growth.