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CHAPTER OUTLINE
I. Financial policy in developing countries encompasses all mea sures intended
to in uence the size, structure, and operation of nancial markets and the sys-
tem of nancial intermediaries. The nancial system plays a key role in devel–
opment by supplying nancial assets (including money, variously de ned), by
mobilizing and allocating savings ( nancial intermediation), by distributing
risk, and by providing monetary authorities with tools for managing economic
stability. The ratio of broad money (M2) to GDP is a common mea sure of
nancial development.
II. The most obvious problem of nancial policy in developing countries has
been controlling in ation. The text distinguishes among chronic, acute, and
runaway (hyper-) in ation and then reviews the sad history of high- in ation
episodes over the past half century. Usually, the source of in ation can be
traced to unmanageable government bud get de cits.
III. Some economists argue that moderate in ation can be bene cial, as it forces
the mobilization of savings by effectively taxing money balances. Some also
contend that in ation may be tolerable as a by-product of keeping aggregate
demand buoyant to stimulate investment. Yet, high in ation probably has the
opposite effects. First, the in ation tax augments domestic savings only if the
government has a higher marginal propensity to save than the private sector,
which is improbable. In any case, in ation is a very distortionary form of tax.
Second, high in ation often is associated with negative real interest rates.
While the link between interest rates and savings is weak, there is no doubt
that negative real interest rates strongly affect the form in which savings are
held. In par tic u lar, negative real interest rates reduce the demand for liquid
assets; this impedes monetization and nancial intermediation. In addition,
Financial Development
and In ation
CHAPTER 12
Financial Development and In ation | 83
negative real interest rates mean nancial institutions must resort to nonprice
rationing of funds. Finally, in ation interferes with price signals and adds to
investment risks. On balance, high in ation almost certainly has an adverse
effect on the level and ef ciency of investment.
IV. Indeed, negative real interest rates are a hallmark of a shallow nancial sys-
tem. Shallow nance results from policies involving repressive interventions,
which retard development of the nancial system. In contrast, deep nance can
be achieved by liberalizing nancial markets and avoiding sharply negative
real interest rates and rapid in ation. A deep nance strategy puts the nan-
cial system to work mobilizing and allocating savings. It also accelerates the
development and ef ciency of the nancial system and helps reduce depen-
dence on informal credit markets.
V. The nal section examines the relationship between monetary policy and
in ation. From the balance sheet for the banking system, one can derive the
fact that money supply growth is determined by the expansion of domestic
credit and changes in international reserves: Δ M = Δ DC + Δ IR. This shows
that money supply expansion, and thus in ation, is linked to credit expansion
for nancing government de cits and private investments and to the balance
of payments. The second term on the right– hand side of this identity implies
that monetary policy is affected by the choice of exchange- rate regime. In a
small, open economy with a xed exchange rate, the monetary authority
must buy and sell international reserves to stabilize the foreign exchange
market; but this means it cannot in de pen dently control the money supply.
Similarly, the need to nance large scal de cits may cause the central bank
to lose control of money supply growth. To the extent that monetary authori–
ties have an in de pen dent role in stabilization policy, they in uence the volume
and cost of credit by determining reserve requirements and the rediscount
rate, by managing credit controls, and by using moral suasion to in uence the
banking system.
Boxed Examples
Box 12–1: Hyperin ation in Peru, 1988– 90
Box 12–2: Does Micro Credit Reduce Poverty?
There are two box studies in Chapter 12. The rst tells the sobering tale of Peru’s
destructive hyperin ation. By 1989, the in ation rate was up to 2,000 percent,
mainly because of huge government de cits. The in ation caused great hardships
affecting daily life and brought the economy to a virtual standstill. The second
examines micro credit and its role in reducing poverty. It speci cally examines
who took advantage of such loans and how they invested or spent the money. This
new edition presents an overview of trends and patterns in world trade. It reviews
84 | Chapter 12
the theory of comparative advantage, discussing both the bene ts of trade and its
distributional consequences. Special attention is paid to trade in primary products,
including “export pessimism” and the terms of trade; Dutch disease and the real
exchange rate; and the “resource curse” and responses to it.
In the New Edition
Chapter 12 of this edition reorders some of the material on monetary policy and
price stability, providing a more intuitive ow to the material. The discussion of
microcredit has been expanded and includes a new box, “Does Micro Credit
Reduce Poverty?,” based on a randomized controlled trial in India.
A small section on the role of government in banking regulation has been
added. All the data are updated, with concomitant revisions to the text. Other
changes are largely editorial.
Class Notes
The importance of Chapter 12 stems from the fact that many developing countries
have been dogged by high in ation. Even more have pursued poor policy with
regard to developing nancial markets. The essence of the chapter can be dis-
tilled into three points. First, the nancial system plays a central role in mobiliz-
ing and allocating private domestic savings. Second, rapid in ation, negative real
interest rates, and other repressive interventions damage the effectiveness and the
growth of the nancial system (shallow nance). The transition to a liberalized
nancial system also is fraught with risks of instability. Third, rapid in ation is
driven by rapid money supply growth, which is attributable to large scal de cits,
excessive expansion of credit, or rapid accumulation of foreign exchange reserves.
Each of these points merits emphasis and explanation in class, although the
degree of detail is your choice.
There are also three items of technical analysis: (1) the determinants of demand
for liquid assets; (2) the sources of change in the money supply; and (3) the money
multiplier. In addition, you can use simple supply- and- demand analysis to illus-
trate the adverse effects of interest rate controls and negative real interest rates.
You also can use supply– and- demand analysis to show why interventions are
needed in the market for foreign exchange to maintain a xed (pegged) exchange
rate, and so lead to endogeneity of the money supply in a xed- rate regime.
Financial Development and In ation | 85
QUESTION BANK
Concept Map
Financial Development and In ation
The Functions of a Financial System
Money and the Money Supply
In ation Episodes
Sources of In ation
Reserve Requirements
Shallow Finance and Deep Finance
Does Micro Credit Reduce Poverty?
1. What, particularly in a developing country, is the most visible and vital com-
ponent of the nancial system (as acceptor of deposits and grantor of shorter–
term credit)?
a. investment banking
b. commercial banking
c. foreign investors
d. hedge funds
2. Which of the following is NOT one of the basic roles essential for the smooth
functioning of the nancial system?
a. a medium of exchange and store of value, called money
b. a channel for mobilizing savings from numerous sources and channeling
them to investors, called nancial intermediation
c. a means of transferring and distributing risk across the economy
d. an ef cient and comprehensive tax system, allowing more revenue for
domestic governments
3. The narrowest mea sure in the money supply is represented by:
a. M1.
b. M2.
c. M3.
d. M4.
4. Which of the following is NOT a liquid nancial asset?
a. currency in circulation
b. time deposits
c. demand deposits
d. foreign aid
5. Total liquid liabilities (M3), the broadest mea sure of money, is the sum of:
a. currency in circulation outside banks plus demand deposits.
b. currency in circulation outside banks plus demand deposits plus time and
saving deposits.
c. currency in circulation outside banks plus demand deposits plus time and
saving deposits plus income taxes.
d. currency in circulation outside banks plus demand deposits plus time and
savings deposits plus liabilities of specialized institutions.
6. During the period beginning in the 1950s and continuing into the 1980s (and
even beyond), Argentina, Brazil, and Chile experienced:
a. chronic in ation.
b. acute in ation.
c. runaway in ation.
d. little to no in ation.
7. Why do developing countries have oating exchange rates?
a. to insulate themselves from world in ation
b. to stabilize government de cits
c. to keep reserves low
d. to keep their money value higher than the dollar
8. A oating exchange rate allows developing countries to:
a. insulate themselves from world in ation.
b. appreciate their currency against the dollar.
c. isolate themselves from trade with developed nations.
d. risk rapid nancial destabilization.
9. Under a system of xed exchange rates, a large increase in export revenues
(without a corresponding jump in imports) has what effect on the domestic
money supply?
a. The money supply will increase.
b. The money supply will decline.
c. The money supply will not be affected.
d. The answer depends on whether the central bank has imposed credit
controls on the commercial banks.
10. What is achieved by having an upward adjustment in reserve requirements?
a. The money multiplier is increased, lowering in ation.
b. It reduces the stock of money that can be supported by a given amount of
reserves.
c. The money multiplier is decreased.
d. Both b and c, which may help moderate in ation.
11. Which of the following is essential to a strategy of deep nance?
a. avoiding a government bud get de cit
b. maintaining very high real interest rates
c. avoiding strongly negative real interest rates
d. all of the above
12. Policies for nancial deepening seek to promote ________ in the real size of
the nancial system, while shallow nance promotes ________ in the real
size of the nancial system.
a. growth; reduction
b. reduction; growth
c. stability; mea sured growth
d. de ation; retraction
13. If a country wants to enact policies for growth in the real size of the nancial
system, nancial deepening, it will require:
a. a negative real interest rate.
b. a negative GDP.
c. a positive real interest rate.
d. a decrease in in ation.
14. According to the box study “Does Micro Credit Reduce Poverty?,” what was
the effect of opening micro credit branches in randomly selected slum neigh-
borhoods as compared to slums without these additional branches?
a. Slums with access to more mirco credit experienced a reduction in pov–
erty within 18 months.
b. Slums with access to Spandana loans opened 1.7% more businesses than
those without access.
c. There was a signi cant increase in total consumption expenditures
between treatment and control areas.
d. Spandana branches had an in ux of borrowers, averaging a total of 70
percent of house holds taking out loans.
IDs and Paired- Concept Questions
These terms can be used individually as short- answer identi cation questions,
or they can be used in pairs. In the latter case, ask students to explain (1) the
meaning and signi cance of each of the two terms and (2) the relationship
between them.
1. Medium of exchange, M2
3. Hyperin ation, government bud get de cit
Financial Development and In ation | 89
5. Shallow nance, informal credit market
7. Real interest rate, deep nance
9. Pegged exchange rate, oating exchange rate
11. International reserves, value of imports
13. Economic collapse, runaway in ation
15. Deep nance, positive real interest rates