Understanding The Role Of The Financial Sector

The financial sector refers to the market for the creation and exchange of financial asset such as money, stocks and bond.

It is very interesting to note that, it is the financial sector which stimulate and facilitate transactions in the real world. The real sector is referred to as the creation and exchange of goods and services. The financial sector plays a central role in almost all aspect of macroeconomic activities. It is so important in our everyday economic transaction such that it cannot be ignored.

As properly framed by economists; that “for every real transaction, there is a financial transaction that mirrors it” Most often, when people think of the economy, they tend to focus on the real sector not appreciating the role and the influence of the financial sector. That is an incomplete view of the economy. The financial sector plays a central role in organizing and coordinating our economy; it makes economic transactions possible. A human cannot live without life; an economy cannot operate without a financial sector. It is practically impossible unless may be we want to go back to the era of barter trading system. This shows how important the financial sector is to the operation of the economy.

The financial sector serves as the lubricant that facilitates the operation of trade that exists in our markets. Let’s consider an example of how the financial sector facilitates trade. Say you walk to a shop and buy a television. You shell out GH¢100.00 and the salesperson hands you the TV. Easy right? Right- but why did the salesperson give you the TV for the little piece of papers?

The answer to that question is; because the economy has a financial sector that has convinced him / her that, that piece of papers has value. To convince him (and you) of that requires an enormous structural system, called financial sector, underlying the TV transaction and all other such transactions. That financial system makes the transaction possible; without it the economy as we know it, would not exist.

The intriguing aspect is that; because the financial sector is running smoothly, you hardly know it’s there, but should the financial system break down, the entire economy would be disrupted; and would either stagnate or go into a recession. This is the more reason why it is very important to underline the impact of the financial sector in our modern day economic transactions.

For every real transaction, there is a financial transaction that mirrors it. For example, when you buy a CD, the sales person is buying GH¢1.00 from you by spending his CD. The financial transaction is the transfer of GH¢1.00 and the real transaction is the transfer of the CD. Because there is a financial transaction that mirrors every real transaction; the financial sector is then considered very important for the proper functioning of the real sector.

Every time there is a flow of both goods and services or factors of production from one sector to another, there is financial flow in the opposite direction. If the financial sector doesn’t work, the real sector doesn’t work. All market transaction requires both the real and the financial sector to be able to function effectively.

The financial sector is again important because of it role in channeling flows of the circular flow chart-such as saving back into the circular flow in the form of loans. The financial sector which comprises of financial markets and institutions channels savings back into spending. This is extraordinary complicated and requires years of study to understand fully. However it can be understood in the simplest form. If the financial sector expands the flow too much, you get inflationary pressures; if it contracts the flow too much, you get a recession; and if it transfers just the right amount, you get a smoothly running economy.

Whiles understanding the underpinnings of the financial sector, the role of interest rate cannot be ignored. Interest rate is the mechanism that equilibrates supply and demand in the financial sector just as price is the mechanism that equilibrates supply and demand in the real sector.

The willingness of individuals and firms to incur financial liabilities is greatly influenced by the interest rate on those financial assets and liabilities.

Interest rate in simple terms is the price paid for the use of a financial asset. For instance, when you deposit cash into an account, the bank pays you interest for the use of your financial asset. In the same vein, when you borrow cash from the bank, you pay interest plus the amount borrowed. When the rate of interest rises, people are less likely to borrow (sell a financial asset) and more likely to save (buy a financial asset). Thus when interest rates falls, there is more borrowing and the opposite is the case.

In order to appreciate the financial sector and the recent trends in global financial flows, perhaps it would be appropriate to have a look at some of the major incidence in history __ the Bretton Woods system.

In July 1994, the procedure for fixing exchange rate and managing international financial system was worked out at a conference held in Bretton Woods, a town in New Hampshire in the US. The Bretton Woods system was designed to ensure that domestic economic objectives were not subordinated to global financial pressures. Under the Bretton Woods system, all countries were required to fix exchange rate to the US dollar, and the dollar was fixed in terms of gold at $35 an ounce.

Since the US emerged as the leading power after World War II, the dollar replaced the sterling as the dominant currency for exchange. Under this system, private financial flows were regulated by capital controls and an international institution, IMF, was set up to monitor the international financial system that was largely dominated by official capital flows. The Bretton Woods system was not universal in its outreach as the communist bloc was not part of it.

However, the rise of Eurocurrency market in the 1960s put strains on the Bretton Woods system. The system suffered a major breakdown on August 15, 1971 when the US; which was unable to deal with a massive speculative attack on the dollar in the wake of growing balance of payments deficit largely caused by the protracted Vietnam War—unilaterally declared that it would no longer honor its commitment to exchange dollars for gold. For some time, a few countries attempted to create alternatives (e.g. the Smithsonian Agreement) to the defunct Bretton Woods system. But on February 12, 1973, Japan decided to float yen against the dollar, and on March 16, 1973, the European Community followed suit. Thereafter, the remaining countries took recourse to either floating or flexible exchange rate system.

Undoubtedly, this system was based on the hegemony of the US as it served the country’s foreign policy and economic interests. Surely, the motive was not altruism on the part of the US but was based on expectation that the country had much more to gain from managing international financial system. Despite its several shortcomings, this system provided adequate financial stability and economic growth for a considerable period (Taming Global Financial Flows by Kavaljit Singh)

ABOUT THE AUTHOR

Paul Frimpong CEPA

Chartered Economist (ACCE-Global) who writes on the macroeconomy and global affairs. He is also an African Affairs Analyst

Tel: +233 -241 229 548 Email: py.frimpong@yahoo.com/py.frimpong90@gmail.com

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