Chapter 13: Financial PolicyChapter 13 OutlineFinancial Policy: IntroductionFunctions of Financial SystemConcepts of Macro-financeInflation and Saving MobilizationSaving Mobilization cont.Financial DevelopmentFinancial StrategyMonetary Policy and Price StabilityStrategies of Controlling inflationChapter13 : Financial Policy Learning ObjectivesTable 13.1: Broad Money (M2) as a % of GDPTable 13.3: Inflation in the across the WorldFig. 13.1: Evolution of Exchange Rate RegimesChapter 13: SummaryChapter 13: Summary cont.End Chapter 13Chapter 13FinancialPolicyNorton Media LibraryDwight H. PerkinsSteven RadeletDavid L. LindauerChapter 13 Outline•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 –Interest-Rate Regulation and Moral SuasionFinancial 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 stabilizationFunctions 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+ OConcepts 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 recessionInflation 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: 1988-90Saving 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 fallsFinancial Strategy •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 desciplineMonetary 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 IRStrategies 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 loansChapter13 : Financial PolicyLearning Objectives •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•CHAPTER OUTLINE•I. Financial policy in developing countries encompasses all measures intended to influence the size, structure, and