The Financial Sector and the Macroeconomy (Edexcel A-Level Economics A): Revision Notes
The Financial Sector and the Macroeconomy
Introduction
The modern economy depends heavily on well-functioning financial markets. For product markets to operate smoothly and for transactions to flow efficiently, there must be adequate availability of money and credit. This note explores the essential roles that the financial sector performs and examines forms of market failure that can hinder its operation.
The financial crisis of 2008/09 provides a clear illustration of how problems in the financial sector can have widespread effects across the entire economy, leading to recession and rising unemployment across multiple countries.
The role of the financial sector
The financial sector creates the environment in which economic activity occurs. It performs several critical functions that enable the economy to operate effectively.
Facilitating saving
Individuals and businesses need opportunities to save money, and the financial sector provides mechanisms to make this possible. This role was highlighted in the Harrod-Domar model when discussing developing countries, but it remains equally important in advanced economies. Financial markets enable savings to be mobilised and channelled towards investment purposes.
People save for various reasons throughout their lives. Households may need to accumulate funds for future spending, which often relates to their position in the life cycle. When young, people may need to save for deposits on houses. Savings are also essential to support individuals in retirement when they are no longer earning regular income.
The financial sector offers opportunities for savers to earn returns on their money. By putting funds aside now, people can have resources available for later use.
When interest rates are low, the returns on savings may not provide strong incentives for people to save, as the rewards are relatively modest. This can have significant implications for the overall level of savings in an economy.
Facilitating borrowing
The opposite side of saving is borrowing. Both firms and households need access to loans, and financial markets provide the mechanisms to obtain them. The circular flow model demonstrates how the saving behaviour of households enables firms to borrow funds to finance their investment activities. This connection between savers and borrowers is a fundamental function of the financial system.
Interest rates play a crucial role in borrowing decisions. The rate of interest represents the cost of borrowing, so firms will only borrow when the expected return on their investment exceeds this cost. Households also need to consider the cost of borrowing when making expenditure decisions, particularly for major purchases.
Facilitating the exchange of goods and services
On a practical level, financial markets need to enable the transactions that occur when goods and services are exchanged. The importance of this function becomes apparent when examining countries that have experienced hyperinflation.
When inflation reaches extremely high levels, people try to avoid using money for transactions. Firms constantly change their prices, and people rush to the bank rather than keeping cash in their pockets. The transaction costs associated with this behaviour are substantial, highlighting the importance of having stable financial systems to facilitate economic exchanges.
Forward markets
Modern financial markets enable transactions to be conducted based on contracts for future delivery. These arrangements are known as forward or futures markets. They are particularly important for transactions involving certain commodities and foreign exchange. Such arrangements provide a way for economic agents to minimise the risks associated with transactions.
Worked Example: Managing Commodity Price Risk
A manufacturing enterprise may need to purchase commodities as inputs for its production process. Given the volatility of some commodity prices, there is uncertainty about what prices will be in future periods.
How futures markets help:
- The firm contracts in advance to buy the commodities they will need at a future date
- An agreed price is set today for the future transaction
- This removes the uncertainty about future costs
- The firm can plan production and pricing more effectively
Result: The firm has protected itself from price volatility and can make more confident business decisions.
The market for equities
The stock market forms an important part of the modern financial system. It enables firms to obtain funds through the share market for their investment plans. The entire business of insurance companies and pension funds is based on the existence of stock markets. These investors (including insurance companies, pension funds and investment banks) purchase stakes in businesses that they view as offering potential for future profits.
The financial sector and the macroeconomy
Monetary policy represents a key way in which authorities seek to stabilise the macroeconomy, but effective monetary policy cannot be implemented without an efficient and effective financial sector.
The importance of the financial sector was dramatically demonstrated by the financial crisis that affected the global economy in the late 2000s. The crisis had far-reaching effects on the stability of the financial system and worked through into the real economy, resulting in recession and rising unemployment. Recovery from this crisis was slow, particularly in some countries such as Greece.
To understand the reasons for the financial crisis and the steps needed to address it, we must first understand how the financial system works and the extent to which it may be subject to market failure.
The macroeconomy relies heavily on the financial sector to operate effectively. Lending and borrowing underpin how the economy works. Firms need to borrow to finance their investment, and households borrow to support their spending. Insurance markets and pension funds are key features of the financial landscape. The process of globalisation enhances the importance of having an efficient foreign exchange market.
The credit crunch and financial crisis, with their impact on economic growth and unemployment, highlighted the critical importance of an effective financial sector for the real macroeconomy. To understand how these problems arose, it is necessary to explore how the banking sector has developed over time, considering the backdrop of deregulation and innovation in types of financial assets.
Financial institutions
Financial institutions provide the crucial link between borrowers and lenders. They are often referred to as financial intermediaries, a term that covers banks, building societies and a range of other specialist institutions that provide financial services.
Traditionally, the banking sector has been viewed as consisting of two main sectors: the retail banks and the wholesale banks.
Retail and wholesale banks
Retail banks are the high-street banks that provide banking services to households and small firms. They accept deposits and make loans, mainly operating on a relatively small scale whilst providing a distributed branch banking service. The rise of internet banking has led to the closure of many high-street branches, but the underlying process of banking remains unchanged.
Wholesale banks operate on a larger scale, accepting deposits and making loans to companies and other banks. These include investment banks and other specialist financial institutions. Building societies in the past were distinct institutions providing a specific service. They accepted deposits from a range of small depositors and made long-term loans for house purchase, with the property acting as collateral on the debt.
Over time, these distinctions have become blurred. Deregulation has allowed most building societies to rebrand themselves as retail banks. The high-street banks have diversified into wholesale banking, becoming universal banks that operate in large-scale lending and investment as well as fulfilling their traditional high-street functions.
How banks operate
Banks operate to make profits. They accept deposits and make loans, earning profit from the return on the loans they make. This profit arises because the interest rates charged on loans are higher than the rates offered to depositors. The more loans banks make, the more profit they receive, but this must be balanced against the need to maintain sufficient liquid assets to meet the demands of depositors who wish to withdraw funds for transactions.
Banks face a trade-off between making loans and holding enough liquidity to service their customers. This fundamental tension shapes all banking operations.
The liquidity ratio is the ratio of liquid assets to total assets. This ratio is crucial for banking operations.
In the short run, banks can borrow from each other to maintain their liquidity ratio. Such interbank lending takes place at a rate of interest that depends on the amount of liquidity in the market and on the period over which the loan is required. The average rate of interest on loans made in the London interbank market is known as LIBOR (London Interbank Offered Rate), which is set daily. Under normal circumstances, such lending ensures that banks have sufficient liquidity on a day-by-day basis, but problems can emerge during financial crises.
Another way of accommodating a short-run shortage of funds is to sell financial assets to the central bank (or to other banks), then repurchase them at an agreed future date, perhaps two weeks later. These sale and repurchase agreements are known as repos, and they act like loans.
Forms of borrowing
Borrowing occurs for various reasons and takes different forms. The nature and characteristics of the borrowing determine the conditions under which borrowing takes place, including the rate of interest charged.
Mortgages
The mortgage market is an important form of borrowing. Mortgages are long-term loans taken out for house purchase, in which the loan is secured against the value of the property. This security arrangement allows for a lower interest rate. If the borrower defaults on the loan, the lender takes the property in place of the debt.
The size of the loan is partly based on the lender's assessment of the borrower's ability to maintain payments over the life of the loan. This assessment may relate to the income and expected income of the borrower, but also to the expectation that house prices will rise in the future.
During the cost of living crisis that arose in 2022, interest rates (including mortgage rates) increased, causing difficulties for many borrowers who had expected interest rates to remain low. This demonstrates how changes in monetary policy can have immediate and significant impacts on household finances.
Unsecured borrowing
Borrowing may also occur without collateral to cover default. Such unsecured borrowing carries a higher rate of interest due to the greater risk involved. In recent years, there has been an increase in very short-run loans to provide households with funds to tide them over until the next pay-day. Such pay-day lending comes at a very high rate of interest.
Another form of borrowing comes through overdrafts. This is an arrangement whereby a bank's customer can spend more than is covered by current deposits at a pre-announced rate of interest. Such borrowing is limited to an amount agreed in advance. Credit cards also allow borrowers to incur debt and allow ready payment for everyday transactions.
Interest rates
Interest rates show substantial variation. This can be explained by examining some key characteristics of the form of borrowing.
The security and length of the loan contribute to the level of risk. It would be expected that lending with no collateral would carry a risk premium, as the cost of default is high for the lender. Risk may also be higher for a long-term loan because of the uncertainty attached to the future.
This may be balanced by the nature of collateral. For example, in the case of mortgage lending, the asset providing the collateral is expected to appreciate in value over time. This was especially true in periods when house prices were rising at a fast rate.
Unsecured loans, such as overdrafts and credit cards, carry significantly higher interest rates than secured loans such as mortgages or government securities, which may be perceived as much less risky.
Financial instruments
The development of new financial instruments in recent decades has had a major influence on the way financial markets operate. Shares are issued by firms in need of finance. Shareholders become part-owners of the company and may receive dividends from the profits made by the firm. Those holding a large portion of a firm's shares can have a major influence on how the firm operates.
When governments need to borrow, one way they can do so is by issuing bonds. A bond is a financial asset that pays a fixed amount each year and also carries a fixed value payable at a fixed date in the future when the bond matures. Bonds can be bought and sold, and the price of the bond varies with the market valuation at any point in time. The price of a bond varies inversely with the rate of interest.
Certificates of deposit (CDs) are one way in which a financial institution can extend its borrowing. These are certificates issued by banks to customers in return for deposits for a fixed term. For example, a large firm may agree to deposit a sum of money for a fixed period, receiving a CD in return. The CD can be sold on in the secondary market, so if the firm needs liquid funds, it can obtain them despite having agreed to the long-term deposit. From the bank's perspective, it knows it does not have to repay the deposit until a fixed point in the future.
Securitisation
Banks have devised ways of selling some of their assets to other financial institutions. For example, suppose a bank has a stock of assets in the form of residential mortgages that generate a regular cash flow. It is possible for the bank to bundle these together and sell them on. This process is known as securitisation, a device that effectively turns future cash flows into marketable securities.
One effect of securitisation is that banks find they need not maintain such a high liquidity ratio to meet their obligations, and can thus expand their lending. This is what happened in the lead-up to the financial crisis of the late 2000s.
Securitisation altered the balance of bank assets, with a higher proportion now being in the form of bonds rather than equity/shares. There is a key difference between the two, because firms can suspend dividends in a difficult year, but the return on bonds has to be paid.
It also turned out that some of the securitisation that had taken place had involved assets and cash flows that were less secure and more risky than had been thought. For example, the so-called sub-prime mortgage market involved some households beginning to default on their debts.
The seeds of the financial crisis
These developments laid the seeds of the financial crisis. Some banks had difficulty in meeting their obligations. Furthermore, with banks holding lower liquidity ratios, the interbank lending system came under pressure. In the UK, the government had to step in to bail out banks that were in difficulties.
As public debt rose, the government cut back on spending at the same time that banks were cutting down on lending. In this way, the crisis spread to the real sector of the economy, resulting in recession.
The impact was also felt through the stock market, where falling share prices put pressure on insurance and pension funds. It became apparent that it is not only the liquidity ratio that is important. Partly through securitisation, banks were holding a wider variety of financial assets, carrying varying amounts of risk. Their ability to meet all demands from their depositors and to cover loan defaults would depend on the bank's capital relative to its current liabilities and assets (weighted by the risk). This is measured by the capital adequacy ratio, defined as the ratio of a bank's capital to the value of its risk-weighted assets.
Market failure in the financial sector
To what extent did market failure contribute to the financial crisis?
Information gap
As securitisation became widespread, there may have been an information gap. Banks were accumulating assets about which they had incomplete knowledge. There was asymmetric information here, as the banks had less knowledge about the assets they were acquiring than the original lenders. This applied particularly to mortgages that were being recycled. Banks were therefore not in a position to come to an accurate estimate of the risk to which they were becoming exposed.
An information gap in the form of asymmetric information may also arise where regulators have incomplete and insufficient knowledge of banks' behaviour, and therefore cannot safeguard the stability of the financial system.
Speculation
The trend towards securitisation spread through the financial system, building into a sort of speculative bubble. Increasing numbers of financial institutions sought to join the profit spree in anticipation of future profitability.
The problem with such bubbles is that once they burst, all suffer together, and problems spread rapidly through the system. This demonstrates how interconnected the financial sector is and how problems in one area can quickly affect the entire system.
Moral hazard
Banks perceived that securitisation meant their risks were well covered, so they were prepared to expand their lending beyond what turned out to be reasonable levels. In other words, banks thought they could take on more risk because they were confident their position was secure.
They may even have realised that their position in financial markets meant that if anything did go wrong, they would be bailed out by governments who perceived them to be too big to fail. This is exactly what transpired. This situation could also create problems in the future if financial institutions believe they will always be bailed out if they get into difficulties.
Externality effects
Once one bank is seen to be failing, the reputation of the whole banking system comes into question. Other banks initially unaffected also come under pressure through externality effects. In this way, contagion can affect the whole financial system and cause lines of credit to dry up as banks become increasingly unwilling to become further exposed by lending.
In the context of pension schemes, people may buy insufficient insurance or accumulate insufficient savings for their retirement, which imposes costs on society when they need to be supported in old age.
The UK government tackled this using the behavioural economics concept of nudge theory, which suggests that people are less likely to opt out of a pension in which they are automatically registered than to opt in to one that is provided. This approach has been very successful in ensuring that more people are enrolled in private pension schemes.
Market rigging
Market failure can also happen through the deliberate and illegal actions of individual economic agents. There have been allegations that some bankers have operated to distort interest rates or exchange rates to make illegal profits.
Case Study: LIBOR Rigging
In 2016, four city traders who had worked for Barclays were jailed for rigging the LIBOR rate. This demonstrates how individual actions can undermine the integrity of entire financial markets and harm consumers and businesses who rely on fair interest rate benchmarks.
The financial sector in emerging and developing countries
Developing countries face particular problems in relation to the financial sector. Stock markets may not exist, or may not function effectively. The provision of banking services to rural areas is fraught with difficulties.
Banks are not readily able to assess the creditworthiness of potential borrowers. There is a situation of asymmetric information, and property rights may be weak, so that borrowers cannot provide collateral that banks would accept. This forces borrowers into the informal market, where local moneylenders have monopoly power and can charge high rates of interest.
The Harrod-Domar approach suggests that saving and investment are crucial ingredients for a strategy to promote economic growth and human development. If funds cannot be raised domestically, then an injection of funds from abroad will be necessary.
Whichever approach is adopted, the financial sector is vital as a way of channelling resources to where they are needed. This needs to be accomplished in a way that addresses areas of market failure. Rural credit markets may need specific attention, but funds also need to be provided for improvements in physical and social infrastructure that will then enable markets to operate effectively. In other words, funds are needed for road and communication links, market facilities and so on. In addition, it is important to be able to invest in human capital by providing education and healthcare and ensuring adequate nutrition for the population.
Success Stories: East Asian Economies
Financial markets that have been able to work effectively have enabled countries to show progress on many fronts. This has been evident in emerging economies.
South Korea and Singapore:
- Laid the foundations for rapid growth in the 1960s
- Found ways of encouraging saving
- Channelled funds into productive investment and infrastructure
- Result: Sustained periods of rapid economic growth
China:
- Success in mobilising foreign direct investment
- One of the key factors enabling growth
- Demonstrated how effective financial sector development supports economic transformation
In sub-Saharan Africa, economic growth has been more elusive. Financial markets have not developed to the same extent as in East Asia, nor have stock markets flourished. Such funds as have been generated (for example, through overseas assistance or international borrowing) have not always been used effectively.
Key Points to Remember:
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The financial sector performs several critical roles including facilitating saving, borrowing, the exchange of goods and services, and providing forward markets for risk management.
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Financial institutions act as intermediaries between borrowers and lenders. Banks operate to make profits whilst managing the trade-off between making loans and maintaining sufficient liquidity.
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Different forms of borrowing carry different levels of risk and therefore different interest rates. Secured lending (such as mortgages) typically has lower rates than unsecured lending (such as credit cards or pay-day loans).
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The financial crisis of 2008/09 demonstrated how market failures in the financial sector (including asymmetric information, moral hazard, speculation and externality effects) can have severe consequences for the real economy, leading to recession and unemployment.
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Developing countries face particular challenges with their financial sectors, including limited access to banking services, weak property rights, and difficulties in mobilising savings for investment. Effective financial systems are essential for channelling resources towards productive investment and economic growth.