5.2 The financial sector

• Define financial market

  When buyers and sellers can buy and trade a range of services or assets that are fundamentally monetary.
• Define Harrod-Domar model

  Savings provide the funds that are used for investment, and growth rates depend on the level of saving and the productivity of investment.
• Define microfinance

  Schemes that aim to give poor and near-poor households permanent access to a range of financial services.
• What is the relationship between the inflation rate and a high interest rate?

  The reward for saving is high and the cost of borrowing is higher, encouraging consumers to save more and spend less, and is used during periods of high inflation.
• What is the relationship between the inflation rate and a low-interest rate?

  The reward for saving is low and the cost of borrowing is low, meaning consumers can access credit cheaply, which encourages spending and investment. Is usually used during periods of low inflation. However, during the Financial Crisis, the UK interest rate fell to a historic low of 0.5% and has been at this rate since March 2009. Despite high inflation, the interest rate was set at a low rate to stimulate AD and boost economic growth.
• Role of the financial sector in the real economy: 1. to facilitate saving

  Financial markets provide somewhere for consumers and firms to store their funds. Savings are rewarded with interest payments from the bank.
• Role of the financial sector in the real economy: 2. to lend to businesses and individuals

  The transfer of funds between agents is aided by financial markets. The funds can be used for investment or consumption.
• Role of the financial sector in the real economy: 3. to facilitate the exchange of goods and services


  Financial markets can make it easier to exchange goods and services from the physical market, by providing a way that buyers and sellers can interact and transfer funds.
• Role of the financial sector in the real economy: 4. to provide forward markets in currencies and commodities

  In commodity markets, investors trade primary products, such as wheat, gold and oil. Future contracts are a method for investing in commodities. This involves buying or selling an asset with an agreed price in the present, but delivery and payment in the future. A forward market is an informal financial market where these contracts for future delivery are made.
• Why is a secure and stable financial sector important in emerging and developing economies?

  To promote economic development because without a financial sector, consumers and firms cannot generate sufficient savings to make the macroeconomy stable.
• What do developing countries only having limited wealth lead to?

  In many developing countries, there is only limited wealth, which means money cannot be put aside for the future, and they can only afford to spend in the S.R. Consumers have to focus on their immediate needs, including food and safe water, to ensure they can survive. Without sufficient savings, there is inadequate capital accumulation.
• Why might it be difficult for capital investment to take place in Africa?

  Africa's saving rate is around 17%, whilst the average for middle-income countries is around 31%. This makes it more expensive for the African public and private sectors to get funds since they have higher borrowing costs. This impedes capital investment.
• What does the Harrod-Domar model state?

  It states that investment, saving and technological change are required in an economy for economic growth. The rate of growth increases if the savings ratio increases, leading to investment and technological progress, which leads to higher productivity.
• How is the rate of growth in the Harrod-Domar model calculated?

  Savings ratio / capital output ratio
• Limitations of Harrod-Domar : 1. reduction in AD

  An increase in savings could lead to an increase in investment. However, an increase in savings means there is a reduction n spending, which leads to a fall in AD.
• Limitations of Harrod-Domar:

  1. reduction in AD

  2. may have a poor financial system

  3. has a low marginal propensity to save in some countries.

  4. funds might not lead to borrowing and investing.
• What does microfinance involve?

  It involves borrowing small amounts of money from lenders to finance enterprises. It increases the income of those who borrow and can reduce their dependency on primary products as well as give them financial independence. These loans have high repayment rates. There could also be a multiplier effect from the investment of the loan.
• How does microfinancing help businesses?

  The loans help detach the poor from high interest, exploitative loan sharks. They could help businesses to be set up, although the money can also be spent on immediate consumption rather than investment. Since the money goes directly to SMEs, it can stimulate employment. However, the data collected on microfinance loans might not be reliable if there is dishonesty regarding where the money was spent.
• Role of the financial sector in promoting economic development: 1. provides funds

  Financial sector facilitates saving, which provides funds for investment and enables consumers and firms to plan ahead.
• Role of the financial sector in promoting economic development: 2. control

  Helps enable control and management of the economy. E.g fiscal and monetary policies.
• Role of the financial sector in promoting economic development: 3. capital

  Financial markets such as the stock market enables firms to raise capital
• Role of the financial sector in promoting economic development: 4. encourages investment

  The finance sector also facilitates borrowing which may encourage investment or enable business expansion. However, it is important to consider some loans have high-interest repayments that could result in higher levels of debt.
• Role of the financial sector in promoting economic development: 5. raising funds


  Governments are able to raise short and long term funds through issuing bonds or bills.
• International finance impact on flow of financial capital in developing and emerging economies: foreign currency gap

  A foreign currency gap exists when the country is not attracting sufficient capital flows to make up for a capital account deficit.
• International finance impact on flow of financial capital in developing and emerging economies: capital flight

  This is when capital and money leave the economy through investment in foreign economies and is triggered by an economic threat like hyperinflation or rising tax rates. It can worsen an economic crisis and cause a currency to depreciate.
• Impact on developing countries of high debt

  With high levels of debt, financial resources are diverted from infrastructure, education and healthcare. If a country defaults on its debt, it can make it harder to borrow in the future.
• Impact on developing countries of debt relief

  Debt relief is the partial or total forgiveness of debt. Debt relief can allow a country to import more, and increase the population's standard of living. It improves gov. finances so public services could be funded instead. However, if the debt is forgiven, it could encourage more borrowing in the future. Also, there could be corruption.