Chapter 14
The Financial System and Economic Growth
◼ Chapter Outline, Overview, and Teaching Tips
Chapter Outline
The Role of the Financial System
Direct Finance
Indirect Finance
Information Challenges and the Financial System
Asymmetric Information
Free-Rider Problem
Financial Intermediaries Address Asymmetric Information Problems
Collateral and Asymmetric Information Problems
Application: The Tyranny of Collateral
Government Regulation and Supervision of the Financial Sector
Government Regulation to Promote Transparency
Government Safety Net
Role of Prudential Regulation and Supervision
Financial Development and Economic Growth: The Evidence
Application: Is China a Counter-Example to the Importance of Financial Development to Economic
Growth?
Chapter 14 Web Appendix: Free Trade, Financial Globalization, and Growth
Chapter Overview and Teaching Tips
With the financial crisis that overwhelmed the world economy from 2007–2009, the public has become
more aware of the interaction between finance and economics. This part of the book provides an analytical
framework for understanding the impact of finance on the economy, both in the short and the long run.
This part of the book will appeal particularly to students who are interested in pursuing careers in finance,
but the material is so topical that almost all students will find it interesting.
Chapter 14 focuses on the long run and examines the role of finance in promoting economic efficiency and
economic growth. The literature on how finance promotes economic growth is fairly recent (developed over
the last twenty years) and is often not sufficiently appreciated either by the public or by many economists.
For example, it was only in the second edition of the leading undergraduate textbook on economic growth
Chapter 14 The Financial System and Economic Growth 153
published in 2009 (David N. Weil, Economic Growth, 2nd edition, Addison-Wesley, 2009) that the role of
finance in economic growth was actually discussed.
The chapter starts by discussing the role of the financial system, illustrating the two routes through which
funds are channeled to households and business: direct and indirect finance. Figure 14.1 is particularly
154 Mishkin • Macroeconomics: Policy and Practice, Second Edition
1. The financial system matches savers (those who have surplus funds) with borrowers who may have
2. In direct finance, borrowers get funds from savers by selling them financial instruments (securities)
such as stocks or bonds. These securities give the lenders (savers) a claim to the borrowers’ future
income or assets. With indirect finance a financial intermediary (such as a bank, mutual fund, or
3. With both direct and indirect finance, the borrower generally has more information than the lender
does about the risk involved. This asymmetric (unequal) information creates two problems for
potential lenders. The people who are anxious to borrow are likely to take greater risks, making it
4. Investors in financial instruments who engage in information collection face a free-rider problem,
which means other investors may be able to benefit from their information without paying for it.
5. To overcome asymmetric information problems, banks screen potential borrowers before making
6. Developing countries likely have weaker accounting and reporting standards, so accurate information
about private firms is more difficult to come by and also more difficult to analyze because of limited
access to information technology. As a result, asymmetric information problems are greater in
developing countries, and local firms, therefore, find it difficult to acquire funds through selling
Chapter 14 The Financial System and Economic Growth 155
7. The government can produce information about borrowers and provide it to investors free of charge,
it can require borrowers to report honest information about themselves to investors, and it can set and
8. Even though banks are well suited to overcome the adverse selection and moral hazard problems
inherent in lending because they make private loans and have incentives to invest in information
production about the borrowers to whom they lend, bank depositors face an asymmetric information
problem of their own: They do not know as much as bank managers do about how much risk banks
9. Governments provide safety nets to reduce the likelihood of bank runs and contagions because these
have adverse effects on the financial system and the economy. Deposit insurance and government’s
assurance that it will make funds available to troubled financial institutions are two forms that a
10. Financial deepening refers to a country developing the institutions necessary to have a well-
functioning financial system. Where it has occurred, the benefits include increasing the rate of
1. A situation in which entrepreneurs cannot get credit to fund their investment projects is not a
desirable one from an efficiency point of view. Although it is true that many ideas will not result in
such a great business as overnight shipping, it is very important that entrepreneurs have access to
funds. The alternative is one in which the economy will not be as healthy because new ideas will not
156 Mishkin • Macroeconomics: Policy and Practice, Second Edition
2. Funds were definitely not allocated to their most productive use. Funds are allocated to their most
productive use when considerations about which individual or firm should receive these funds are
based on risk and expected returns associated with the investment. The situation in which funds are
allocated based on political positions results in an inefficient allocation of funds, and as a consequence,
3. a. The loan officer is trying to assess your credit risk by gathering information about your income (past
and current employment) and credit history to avoid the adverse selection problem. The loan office
is essentially making sure that you will have the ability and willingness to pay back your car loan.
b. By putting a lien on your car title, the bank solves (or reduces) the moral hazard problem. The bank
wants to make sure you will use your loan to buy a car (a problem that is sometimes solved by
writing a cashier’s check with the car dealer’s name on it) and that you will not sell the car, recover
4. During your visit at the bank you will probably realize that your will receive an annual interest rate of
1 percent or 2 percent if you buy a certificate of deposit, while an individual asking for a car loan will
be required to pay an annual interest rate of 7 percent or 8 percent. At the beginning, it seems
tempting for you to offer an interest rate of 4 percent, which would make both of you better off.
However, you would probably like to know that individual better, in particular his net worth (to
assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?).
5. Information asymmetries are also present in government bond markets. Usually investors resort to
many information sources about the characteristics of particular governments to assess their ability or
willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack of information
results in huge losses for bondholders. In this respect, the problem is not significantly different from
Chapter 14 The Financial System and Economic Growth 157
6. Financial intermediaries operating in countries with relatively weak property rights and legal systems
usually require a lot of collateral when making loans. The rationale for that behavior is that in the event
that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its
loan. Therefore, requesting extra collateral might help the bank speed up the process. In practice, a
bank that has requested two other houses as collateral for a mortgage has better chances to recover its
loan in the event of default. Of course this means that fewer individuals will have access to mortgages
7. In the U. S. financial system, trading in derivatives is concentrated in five large banks and
transactions are kept relatively private, for the same reason that banks do primarily private loans (to
avoid the free-rider problem). Some senators want to create a clearinghouse to operate as a “middle
man” in this market and to make information about derivatives prices publicly available to increase
8. Although it might seem a good idea to “copy and paste” regulatory frameworks that ensure the
soundness of a financial system from one country to the other, this is usually not a good idea.
Developed and developing countries have quite different financial systems. Incorporating a system of
deposit insurance will surely result in an increase in deposits at financial intermediaries. However,
9. As more individuals and firms participate in the financial system, monetary policy becomes more
effective. When more firms and borrowers rely on financial intermediaries, monetary policy tools
have a more immediate effect on monetary aggregates. Monetary policy tools affect financial
intermediaries’ ability to create loans and therefore to increase the supply of means of payment (i.e.,
money). If most individuals rely on the financial system as a source of funds, a contractionary
158 Mishkin • Macroeconomics: Policy and Practice, Second Edition
10. Microcredit programs were very effective in defining a set of incentives that helped to deal with
asymmetric information problems. As a result, microcredit loans usually exhibit higher repayment
rates (the percentage of loans that are actually repaid) than regular loans made by financial intermediaries.
Solving the adverse selection problem was never the intention of microcredit schemes because the
target population are the extreme poor, who are individuals who live on less than $1 per day and
usually do not possess collateral. But making sure that the recipients of the loans have strong
1. a. For June 2013, the AA nonfinancial commercial paper spread was 0.05, and the AA financial
was 0.12, slightly higher than the most recent reading and indicating slightly higher risk. In
October 2008, these spreads widened significantly to 1.40 and 2.52, respectively. Asymmetric
information played a large part in the financial crisis in late 2008; thus, interest rates rose sharply
to compensate for the information problems. The spreads are much smaller today, indicating a
Chapter 14 The Financial System and Economic Growth 159
2. a. From 2013:Q1 to 2012:Q2, the average percent of loans secured through collateral was 51.3
percent, down from 58.4 percent from the previous four quarters. During the same time frame,
the average of senior loan officers reporting a net tightening was –7.9 percent during the recent
period and –9.7 percent in the previous four quarter period, indicating an easing of credit
standards over both one year periods. The St. Louis stress index averaged –0.4 from 2013:Q1 to
2012:Q2 and slightly higher at 0.1 during the previous four quarters.
b. The average percent of loans secured through collateral in 2008 was 53.1 percent, up from 46.6
percent in 2007. During the same time frame, the average of senior loan officers reporting a net
3. a. See table below.
b. See table below. There is a clear relationship between financial/investment freedom and per
capita growth in the data: from 1995 to 2005, the top three countries grew by 2.9 percent, while
the bottom three grew by only 1.62 percent. From 2005 to 2011, the top three grew by almost 1
percent, while the bottom three shrank slightly with a –0.12 percent growth rate
c. Changes in the overall score don’t seem to matter as much as the overall score itself. Czech
Republic and Australia had relatively high scores to begin with, and they had strong per capita
160 Mishkin • Macroeconomics: Policy and Practice, Second Edition
1. Financial repression refers to efforts to impede the development of financial markets and institutions
2. Financial repression is supported by government officials and rich elites in developing countries.
3. Free trade increases competition that reduces the revenues and profits of firms in developing
4. Financial globalization opens markets to flows of foreign capital and competition from foreign financial
institutions. This gives domestic financial institutions incentives to become more efficient and adopt
the procedures and technology that their new competitors use. Domestic regulators also learn the practices
that foreign institution use and promote their use by domestic institutions. Globalization increases the
availability of funds, which lowers interest rates and leads to greater investment and economic growth.
It can also increase public support for the adoption of accounting standards, disclosure requirements,
and other institutional reforms that make it easier to get useful information for lending decisions and
Chapter 14 The Financial System and Economic Growth 161
to reform the legal system to protect lenders’ claims to collateral and to enforce restrictive covenants
in loan contracts. Reforms such as these further promote economic growth.
◼ Data Sources, Related Articles, and Discussion Questions
A. For Information About Application: The Tyranny of Collateral
Data Source
De Mel, Suresh et al., “Who Are the Microenterprise Owners? Evidence from Sri Lanka on Tokman v. De
Soto”: http://econ.worldbank.org/external/default/main?pagePK=64165259&piPK=64165421&
theSitePK=469372&menuPK=64216926&entityID=000158349_20080527134815. This paper uses an
empirical approach to show that access to funds is not the only constraint to small enterprises’ growth.
This evidence complements the argument that small businesses and entrepreneurs in developing countries
face many problems (the absence of collateral that prevents them from accessing funds being one of them).
Related Article
Darlington, Shasta (CNN), “Rio slum transformed into canvas bursting with color”:
http://www.edition.cnn.com/2010/WORLD/americas/11/17/brazil.beautiful.favela/index.html. In this
CNN article, you can observe the scope of illegal construction in one of the largest metropolises of South
America: Rio de Janeiro. This is mainly a consequence from the lack of collateral needed to get a
mortgage loan (note especially picture 8).
Discussion Question
During the most virulent phase of the 2007–2009 financial crises, the U.S. government enacted measures
to prevent the increase in foreclosures, as many families were losing their homes. Many people criticized
this action, arguing that seizing collateral in the event of default was part of the mortgage contract. Explain
how this situation exemplifies the role played by collateral in solving asymmetric information problems.
162 Mishkin • Macroeconomics: Policy and Practice, Second Edition