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Role of Financial System in Economic Development

Introduction

A strong financial system is the backbone of a modern economy. There is a direct correlation between Financial Deepening (growth of financial system) and Economic Growth.

1. Key Contributions

1. Capital Formation

  • Economic development needs huge capital.
  • The financial system facilitates Capital Formation by mobilizing scattered savings and channeling them into industries.

2. Allocation of Resources

  • Funds are scarce. They must go to the most efficient projects.
  • Financial markets price perception allows funds to flow to high-growth sectors (e.g., IT, Pharma) rather than declining ones.

3. Promotion of Trade & Infrastructure

  • Banks provide Working Capital (Trade finance) preventing bottlenecks.
  • Bond markets provide Long-term Capital for roads, bridges, and power plants.

4. Encourages Entrepreneurship

  • New ideas need Venture Capital.
  • Availability of risk capital encourages innovation and startups.

1. Savings Mobilization

  • Indians are natural savers. The system encourages savings by providing safe instruments (FDs, PPF).
  • Impact: Higher savings = Higher Capital Formation.

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5. Foreign Capital

  • A robust financial system attracts Foreign Direct Investment (FDI) and FIIs, supplementing domestic savings.

2. The Cycle of Growth

Better Financial System -> Higher Savings & Investment -> Higher Capital Formation -> Higher Production -> Economic Growth.

Summary

  • Capital: Turns savings into investment.
  • Efficiency: Allocates funds to best users.
  • Innovation: Supports startups (VC).
  • Infrastructure: Funds long-term projects.

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