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Role of Financial System in Economic Development

Mr. C.S. Sudheer | Posted On Monday, June 23,2008, 02:02 PM

Role of Financial System in Economic Development




The role of financial factors in economic development is a accepted notion. Financial factors influence economic growth and development by affecting the amount of savings and the intermediaries of these savings to investment opportunities that bring highest rates of return.
A repressed financial system coupled with high inflation is believed to impede in a number of ways with economic growth and development of a nation. Such a repressed financial system is characterized by.

1. Underdeveloped savings vehicles or negative returns on savings or both.

In a repressed financial system, savings vehicles are under-developed. In other words banking facilities, financial services are lacking in such a system which induce persons to save and accumulate income in a repressed financial system the returns on savings may be negative and unsuitable or both.

There are two immediate consequences of under-developed and negative returns on savings.

  •  Firstly, the low and possibly negative returns on savings discourage rates of savings in an economy, which ultimately influence investment.
  • Secondly, any money that is saved will end up into self-finance on unproductive expenses.

2. Inefficient allocation of savings by financial intermediaries.

In a repressed financial system, financial intermediaries which collects savings deposits from the people are not in a position to allocate these savings affectively because interest rates on loans are regulated by the government funds are rationed into priority and non-priority areas which reduces the productivity of investments and ultimately the growth.

3. Poor financial policies discourage forms investing

Also firms are discouraged from making investment. Financial policies of government, which are distortionary in nature particularly, price controls, over valued domestic currency and high inflation due to deficit financing augment risks of doing business and consequently and adversely affect the investments by firms and industries in investment projects. Besides depressing investment in the economy and unstable business environment and the rationing of investible resources into priority and non-priority also induce the wasteful use of resources for rent seeking. This is due to financial repression, which creates an environment where business firms can secure large contracts from the public sector by satisfying rent seeking class.

Thus the financial system of a country is of immense use in its economic development because capital formation helps in economic development which is possible only when the financial system functions efficiently the volume and growth of the capital in the country very much depends on the efficiency and intensity of the operations and activities in the financial markets. Hence for a country to progress on the economic front it is necessary that’s its financial system works efficiently.


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