Role of Financial System in Economic Development

ECONOMICS
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The neoclassical economics advocates that as capital is formed, there is expansion of labour
force coupled with change in technology which automatically leads to rising GNP and
economic development. However, this view has limited empirical support and increasingly
structuralism is becoming the predominant theory offering explanation for economic
development. This theory is based on more productive use of capital and labour through the
use of technology (Ahuja, 2016). Support with regards to this theory can be garnered from
the economic differences between the developed and developing countries. The former tend
to deploy capital and labour towards higher productive segments such as services unlike the
latter where capital and labour deployment is continuing towards less productive agriculture
and manufacturing sector (Basu, 2014).
Considering that capital and resources ought to be deployed to segments having higher
productivity, thus, investment is required in these segments. The mainstream development
economics links investment to savings and advocate that higher savings would automatically
trickle into high investment. However, empirical evidence does not support this hypothesis
considering that there are developing countries with very high savings but the development
rate has remained stagnant. The financial system tends to play a key role in ensuring that the
savings are productively deployed into making fresh investments (Roland, 2015).
One of the key components of the financial system is financial intermediaries such as banks
and other financial institutions which tend to mobilise household savings as deposits and tend
to deploy the same to the most productive sectors as credit. Private investment also require
high consumer spending in order to ensure high capacity utilisation and expansion of new
capacities (Basu, 2015). It is imperative to note that banks also provide finance to
microfinancing institutions which lend to small entrepreneurs thereby allowing them to
improve productivity The financial intermediaries also aid in this process by providing
credit to retail consumers for making various purchases such as automobiles, services, real
estate and other products. Hence, in the absence of financial intermediaries both private
investment and consumer spending would lapse (Janvry and Sadoulet, 2016).
Another key component of financial system exists in the form of capital markets. Capital
markets provide a reliable means whereby private investment can be boosted as the
companies can raise money directly from retail and institutional investors through the issue of
debt and/or equity instruments (Ahuja, 2016). Besides, it also provides a mechanism for the
households to enhance their income through capital gains and dividend income. This in turn