The Role of Finance in the Real Economy Finance Sector Essays The Role of Finance in the Real Economy

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macroeconomic performance Potential Essays Evaluate the relevance of the quantity theory of money Evaluate the role of the financial sector in the real economy What does it do? How does it impact the macroeconomic performance indicators? Is it effective? Depends on ….?

Role – What does the financial sector do? Facilitates saving Which in turn finances lending enabling C &  I   AD Also lends to government to enable  G Facilitates the exchange of goods and services through payment systems (e.g. cheques, credit cards, electronic transfer of money)   transactions   C,  I,  X and M impacting economic growth Provides forward markets Enables firms to be certain about raw material costs, increasing confidence

Role – What does the financial sector do? Provides market for equities (shares) Enables enterprise profit sharing and investment Provides insurance Gives firms & households more security / confidence

Analysis – how does this impact the macroeconomy Effective and efficient financial institutions and markets enable economic growth to occur Economic growth is primarily driven by C & I much of which relies on credit – small firms in particular are unlikely to growth without credit Economic growth enables more jobs and increases exports

Analysis – use diagrams to aid your analysis

Counter analysis An inefficient and / or unstable financial sector can cause major issues in the macro economy. Many causes of market failure: Lending out money which cannot be repaid – Asymmetric information Bank may not realise the full risk of certain loans Example – sub-prime mortgage loans in the USA However, these were batched up with other financial products and sold on – SECURITISATION – and again due to asymmetric information, the buyer of these product bundles may not understand the risk

Causes of market failure - continued Low liquidity ratio This may mean the banks have insufficient funds to meet consumer demand for their savings back This happened in 2008 as people started to default on the sub-prime mortgages impacting financial institutions who had bought securitised product bundles (e.g. Northern Rock) The inter-bank lending system was also under pressure so the government had to step in This led to the ‘Credit crunch’ where banks stopped lending and this coupled with a fall in confidence led to  C and  I and therefore  AD exacerbated by the negative multiplier effect

Causes of market failure continued Moral Hazard Because banks know they will be bailed out by the government, there is a tendency to take more risk than they perhaps otherwise would have done Banks have had a tendency to pursue short-term profits Externalities For example the cost of bailing out RBS, Lloyds and Northern Rock is borne by the taxpayer (hopefully will be reimbursed) Estimated at £2,152 per person in the UK

Causes of market failure continued Bubbles – Housing Market Banks crucial in lending finance to enable people to buy property. But tendency to lend too much D for houses  P and ultimately to housing bubbles if allowed to escalate When bubbles burst (property market crashes) people have negative equity and may be unable to repay the banks This reduces their CAPITAL ADEQUACY RATIO – which means they may be less able to meet demands from depositors

Evaluation – financial sector effective? Vital in terms of enabling CF of I , efficiency in other markets and economic growth Stable and secure financial secure – very effective However, market failure in financial sector can have devastating effects on macro economy Therefore, financial sector most effective if appropriately regulated ensuring adequate liquidity ratios maintained, better transparency in information provision and reasonable capital adequacy ratios are maintained.