A mature, well functioning financial system and institutions is critical to maximum economic growth. Discuss completely the role of financial markets, institutions, and instruments (sources and uses of funds) in sustaining and augmenting economic growth. Include in your response a discussion of direct finance and indirect finance, the money market and capital market, and the problem depository institutions face in managing their assets (use of funds) and liabilities (source of funds). Solution Financial System and Economic growth: Financial systems, i.e. financial intermediaries and financial markets, are important for economic growth. They can lead to a more efficient allocation of resources because they reduce the costs of moving funds between borrowers and lenders, and help overcome an information asymmetry between borrowers and lenders. If they do not function well the economy cannot operate efficiently and economic growth will be negatively affected. 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, favouring a better allocation of resources and thereby economic growth. The Role of Financial Markets, Institutions, and Instruments sustaining economic growth: 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. The role of finance in economic growth will have policy implications and shape future policy-oriented research. The impact of finance on economic growth will influence the priority that policymakers and advisors attach to reforming financial sector policies. Furthermore, convincing evidence that the financial system influences long-run economic growth will advertise the urgent need for research on the political, legal, regulatory, and policy determinants of financial development. In contrast, if a sufficiently abundant quantity of research indicates that the operation of the financial sector merely responds to economic development, then this will almost certainly mitigate the intensity of research on t.

1. A mature, well functioning financial system and institutions is critical to maximum economic
growth. Discuss completely the role of financial markets, institutions, and instruments (sources
and uses of funds) in sustaining and augmenting economic growth. Include in your response a
discussion of direct finance and indirect finance, the money market and capital market, and the
problem depository institutions face in managing their assets (use of funds) and liabilities (source
of funds).
Solution
Financial System and Economic growth:
Financial systems, i.e. financial intermediaries and financial markets, are important for
economic growth. They can lead to a more efficient allocation of resources because they reduce
the costs of moving funds between borrowers and lenders, and help overcome an information
asymmetry between borrowers and lenders. If they do not function well the economy cannot
operate efficiently and economic growth will be negatively affected.
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, favouring a better allocation of resources and thereby economic growth.
The Role of Financial Markets, Institutions, and Instruments sustaining economic growth:
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.
The role of finance in economic growth will have policy implications and shape future
policy-oriented research. The impact of finance on economic growth will influence the priority
that policymakers and advisors attach to reforming financial sector policies. Furthermore,
convincing evidence that the financial system influences long-run economic growth will

2. advertise the urgent need for research on the political, legal, regulatory, and policy determinants
of financial development. In contrast, if a sufficiently abundant quantity of research indicates
that the operation of the financial sector merely responds to economic development, then this
will almost certainly mitigate the intensity of research on the determinants and evolution of
financial systems.
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. 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.
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. In countries with a highly developed financial system, we observe that a greater share of
investment is allocated to relatively fast growing sectors.
The impact of money markets and capital markets in Economic Growth:
Financial markets play an important role in the mobilization of financial resources for
long-term investment through financial intermediation. The existence of money markets
facilitates trading in short-term debt instruments to meet short-term needs of large users of funds
such as governments, banks and similar institutions. Government treasury bills and similar
securities, s well as company commercial bills, are examples of instruments traded in the money
market.
A wide range of financial institutions, including merchant banks, commercial banks, the
central bank and other dealers operate in the money market. Public as well as private sector
operators make use of various financial instruments to raise and invest short term funds which, if
need be, can be quickly liquidated to satisfy short-term needs. Unlike the money market, the
capital market mobilizes long-term debt and equity finance for investments in long-term assets.
Capital markets also help to strengthen corporate financial structure and improve the general
solvency of the financial system.
The problem depository institutions face in managing their assets (use of funds) and liabilities
(source of funds):
Economic value risk is the exposure to a change in the underlying value of an asset. As
interest rates increase (or decrease), the value of fixed-rate assets decreases (or increases)
because of the discounted present value of the cash flows. To the extent that the change in

3. market value of the assets differs from the change in market value of the liabilities, the difference
is realized in the market value of the equity of the FI.
For example, for most depository FIs, an increase in interest rates will cause asset values to
decrease more than liability values. The difference will cause the market value, or share price, of
equity to decrease.