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Knowledge Corner

Economics & Financial Markets – 3

Difference between financial markets & other markets
Financial markets are different from other markets in the economy. They are much more complex and have a number of special characteristics, which make them rather unique. Because of the special nature and characteristics of the financial markets, they require a special set of rules and regulations. This section will discuss some of these characteristics in more detail.
Systemic Risk
Financial markets are characterized by a complex and dynamic network of inter-relations among major intermediaries like banks, financial institutions and securities markets. Also, a large number of borrowers and lenders are dependent on the financial system. One of the important characteristics of the financial markets is that it is a source of systemic risk. Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It refers to the risks imposed by interlink ages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bring down the entire financial system and even severely affect the real sector in the economy. This phenomenon is very special to the financial market. Over the years, systemic risks of the global financial markets have increased. Innovation in financial tools have continued to foster the growth of risk transfer instruments, such as derivatives and structured products, while deregulation and technological improvement have helped to further increase the growth of cross-border activity and the entry of new market participants. All these have increased the systemic risk of the system. Banks and financial institutions of the world are now more dependent on each other and any shock happening to one of the bigger financial centers of the world is likely to affect the entire global financial system. This was evident during the housing market crisis in USA. A collapse of house prices in USA affected the banking system and eventually snowballed into a full-fledged Crisis in the developed world. Most developing countries were also affected, in spite of having little exposure to the US mortgage market.
Asymmetric Information
Information asymmetry is a situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. This could potentially be a harmful situation because one party can take advantage of the other party’s lack of knowledge. Asymmetric information is an important characteristic aspect of the financial market. Although asymmetric information is not something exclusive to the financial market, the extent of this problem is relatively deeper in this market than in other markets. Asymmetric information has received significant attention in Economics in recent times. Three Nobel laureates George Akerlof, Michael Spence and Joseph Stieglitz have made pioneering contributions to this field. In financial markets, information asymmetry can happen because of a number of reasons. For example, a borrower has much better information about his financial state than the lender. The lender has difficulty knowing whether it is likely that the borrower will default. To some extent, the lender will try to overcome this by looking at past credit history and evidence of salary. However, this only gives limited information. The consequence is that lenders will charge higher rates to compensate for the risk. If there was perfect information, banks wouldn’t need to charge this risk premium.
Feedback and Amplification
Information asymmetry is presented not only in financial sector but in some other economic sectors as well, but the presence of systemic risk together with information asymmetry result in another problem in the financial system: that is, a much stronger feedback and amplification mechanisms than in other sectors. For example, because of the presence of systemic risk and information asymmetry, even a rumor about a bank run can create panic in the financial market 28. There are also issues of ‘herd behavior’ and ‘contagion’ in the financial markets. Herd behavior is a tendency for a group of individual to mimic the actions (rational or irrational) of a larger group. Herd behavior can be observed during stock market bubbles/crash when there are periods of frenzied buying/selling. In India, FIIs tend to have a disproportionately high level of influence on market sentiments and price trends. This is so because other market participants perceive the FIIs to be infallible in their assessment of the market and tend to follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other market participants amplifies the importance of FIIs in the domestic stock market in India. These special characteristics and features of financial markets imply that these markets are to be regulated and governed by specialized institutions. This is the reason why there are so many different forms of financial institutions in the economy. Each of these institutions has a role to play in either promoting the basic roles of finance or to tackle some of the problems, which are specific to the financial markets.
- Money and Monetary Policy -
What is the role of Money?
Money plays a number of extremely important roles in a modern economy. The most obvious role of money is as a medium of exchange. During the early days of human civilization, it was realized that the barter system suffers from the problem of “double coincidence of wants”. This means that a barter system will only work if two persons can be found whose disposable possessions mutually suit each other’s wants. In a country or in an economy, there may be many people wanting a particular good and there may be many people who possess those things wanted, but to allow barter or a direct exchange of goods to happen, there has to be a double coincidence of wants. For example, to have his food, a hungry tailor will have to find a farmer who needs a shirt. This is unlikely to happen. The second problem with a pure barter system is that it must have a rate of exchange, where each commodity is quoted in terms of every other commodity. This complication can be avoided if any one commodity be chosen, and its ratio of exchange with each other commodity is known. Such a commodity can be used as a unit of account or a numeraire. To overcome these problems of barter, use of a commonly accepted medium of exchange started. This medium also acted as a measure of value. Different civilizations used different commodities as the medium of exchange. In some African countries, the medium of exchange was decorative metallic objects called Manillas.
The Fijians used whales’ teeth for the same purpose. In some parts of India, cowry or sea shells were used as the medium of exchange and measure of value. Such usages of commodities as the medium of exchange and measure of value correspond to what we presently call ‘Money’. By the 19th century, commodity money narrowed down to usages of precious metals like silver and gold. This however limits the amount of money in the economy as it is constrained by the availability of precious metals which are exhaustible resources. Since then we have moved to an era of paper money. The use of paper money has become widespread because it is a convenient medium of exchange, is easy to carry and store and is also a measure of value for the large number of goods and services produced in a modern economy. The value of money stems from the fact that private individuals cannot legally create money. Only designated authorities are allowed to supply money. This limitation in the supply of money ensures that money retains its value. This also means that money can also be viewed as a store of wealth. Therefore, to summarize, money has three broad roles in an economy:
  • a) It is a medium of exchange
  • b) It is a measure of value
  • c) It can be used as a store of wealth
It is worth pointing out here that modern currencies are not backed by any equivalent gold or silver reserves. Based on a host of macroeconomic factors, the government or the central bank decides the amount of money to be supplied to an economy.
Components of Money in India
General terms, it can be said that money consists of coins, paper money and withdraw able bank deposits. Bank deposits are part of money supply because one can write cheques on these accounts and the cheque possesses the essential qualities of money. Moreover, increasingly credit cards and electronic cash are becoming an important component of the payment system. Continuing financial innovations are causing widening of the definition of money.
The Reserve Bank of India (RBI) publishes 4 measures of monetary aggregates in India. These measures define money based on progressive liquidity or spend ability-
  • M1= currency held by the public (currency notes and coins) + Demand deposits With the banking system (on current and saving bank accounts) + Other demand deposits with RBI.
  • M2 = M1 + saving deposits with Post office savings banks.
  • M3 = M1 + time deposits with the banking system.
  • M4 = M3 + total deposits with the post office savings organization (excluding National Savings Certificates).
M1 represents the most liquid form of money among the four money stock measures adopted by RBI. As we proceed from M1 to M4, the liquidity gets reduced. In other words, M4 possesses the lowest liquidity among all these measures. The importance of all these four money stock measures varies from the point of view of monetary policy.
Demand for Money
There are three motives underlying the demand for money i.e. transaction demand for money, speculative demand for money and precautionary demand for money. These three motives are explained below.
First, the transaction motive of demand for money (also called transaction demand for money) means that money is demanded to carry out certain transactions. It is likely to be positively related with income. This is simply because higher the income of an economic agent, higher is the expected volume of economic transaction. To facilitate higher volume of economic transactions, more money is required. However, the transaction demand for money is influenced by the prevailing rates of interest and the expected rate of return on alternative assets like shares. This is because money held in the form of idle cash provides liquidity and facilitates economic transactions but it does not give a positive return. Therefore, the economic agents will be facing a tradeoff between the utility they derive from the liquidity of the available cash and the expected return they are forgoing on alternative assets. So, they will try to economize on their money holding, when the expected returns on alternative assets go up.
The second motive to demand money is called speculative motive. The demand for money arising out of speculative motive is called speculative demand for money. The speculative demand for money depends on people’s expectation of the future interest rate movements. John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate does fall, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate. The speculative demand for money is low when people expect interest rates to fall in future and vice versa.
Thirdly, the precautionary demand for money arises because of uncertainty regarding future income. For example, one does not know when one would fall sick or have accident or need money for some unforeseen requirement. The money demanded to cover these expenses is called precautionary demand.
Supply of Money
The world has transited from commodity money to paper money. A ‘commodity money’ like gold, silver or copper has some intrinsic value. That means that even if the commodity is not used as money, it will have some value of its own. However, the same cannot be told 44 about paper currencies. A paper currency note does not have any intrinsic value or value of its own. Such type of money is called “fiat money”. A ‘fiat’ is an order and fiat money is established as money by government order. When an economy relies on fiat money, some agency is required to regulate and support fiat money.
In most countries, a ‘Central Bank’ has been created to support fiat money, oversee the banking system and regulate the quantity of money supply in the economy. In India, the Reserve bank of India (RBI) is the central bank. Other examples of central banks are Federal Reserve or Fed in the USA, the Bank of England in UK and the European Central Bank in the Euro area.
Use of Monetary policy
RBI is the apex institution in administering the monetary policy measures in the Indian economy. RBI’s conduct of monetary policy has been guided by the twin objectives of maintaining price stability and enhancing economic growth. The prevalent phase of business cycle determines RBI’s direction of monetary policy. In case of high inflationary situation, which typically happens when the economic growth is robust, RBI takes contractionary monetary policy measures by raising key policy rates like CRR, repo and reverse repo rates to absorb excess liquidity from the system. By resorting to such measures, RBI essentially tries to reduce the money supply in the economy which leads to a rise in the interest rates. Rising interest rates reduce aggregate demand and thereby contain inflationary pressure.
However, the pace of economic growth would be affected under such policy framework. Since we are talking about a phase of business cycle, when the GDP growth is already very high, the RBI does not mind if the growth rate gets reduced somewhat, as long as it is able to bring inflation rate down to what it is comfortable with. On the other hand, think of a situation when the economy gets into a recessionary phase and the economic growth slows down. Note that during the recessionary phase, inflation rate is typically very low. What does the RBI do in this case? RBI resorts to expansionary monetary policy measures by reducing key policy rates.
This results in reducing the market interest rates. Reduced interest rates augment the investment activity and thereby increase the total output and employment in the economy. This may however lead to some increase in inflation. But the RBI does not mind that. Thus, the RBI uses monetary policy instruments differently at different times, depending on what is the most pressing concern of the economy: high inflation or low GDP growth. When inflation is the major concern, it tightens monetary policy (that is, it reduces growth in money supply) and when sluggish economic growth is the major concern, it loosens monetary policy (that is, it attempts to increase growth rate of money supply).
Use of Fiscal policy
The kind of policy objectives that can be achieved through the use of monetary policy can also be achieved by fiscal policy instruments (see below). While the RBI determines the monetary policy, it is the government that determines a country’s fiscal policy. Many times, appropriate monetary policies are combined with fiscal policies to have the desired impact 51 on the economy. When an economy gets into a recessionary phase, the government can use fiscal policy to boost the economic activity in the country. Tax rate and public expenditure are the main instruments of fiscal policy. To revive growth during recessionary phase, government resorts to expansionary fiscal policy measures which means that it reduces the tax rates and/or increases the public expenditure. A cut in direct taxes, for example, raises the disposable income of people. This will encourage many people to raise their spending, which will boost the aggregate demand in the economy. Similarly, a reduction in indirect taxes makes the goods cheaper and more affordable, leading to higher spending by people. Now what impact does increase in government expenditure have at times of recession? An increase in public expenditure raises the aggregate demand in the country. This works very well when the economy passes through recessionary phase.
During normal times, however, there are problems associated with raising public expenditure beyond a certain level or lowering tax rates beyond a point. Higher public expenditure and/or lower tax revenue would push up the fiscal deficit of the government. In order to finance the fiscal deficit, government would have to
  • Borrow money from open markets or
  • Monetize the deficit (that is, print more money).
In the former case, it would crowd out private investment. In other words, higher market borrowing by the government would mean less investible resources for the private sector. Since private investment is typically more productive than public expenditure, part of which are for non-productive purposes such as subsidies, the economy suffers when fiscal deficit rises to very high level. Persistence of such huge fiscal deficit would also affect the country’s image in foreign countries which may make it difficult for the domestic country to borrow abroad funds.
To the extent, government finances the deficit by printing money; it would increase money supply in the economy which will push up the rate of inflation. Hence, there are limits on the extent to which the government can use expansionary fiscal policy to raise economic growth rate. There is one difference between the use of monetary policy and fiscal policy. Monetary policy generally impacts all sectors of the economy in a similar way. For example, if the RBI follows tight monetary policy, interest rates rise and affect growth of all sectors in the economy. It is possible to use fiscal policy to have differentiated impact on different sectors of the economy. For example, it is possible to reduce tax rates on some goods that exhibit low growth rates, so that their growth picks up and at the same time, raise the tax rates on very fast growing sectors to mop up large tax revenue.
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