The Role of the Financial System

• Providing payment services

• Matching savers and investors
• Generating/distributing information
• Allocating credit efficiently
• Pricing, pooling, and trading risks
• Increasing asset liquidity
 The role of central banks

– Issuer of currency and manager of foreign

reserves
– Banker to the government
– Banker to domestic commercial banks
– Regulator of domestic financial institutions
– Operator of monetary and credit policy
• Financial liberalization, real interest rates,
savings, and investment
– Rationing
– Financial repression
The Effects of Interest-Rate Ceilings on
Credit Allocation
 Financial Intermediation and Economic Growth

•Finance and growth

•Different channels through which financial development
stimulates economic growth.
•Financial development enhances efficiency in the allocation
of resources, thus stimulating the growth process.
•The financial system reduces liquidity risk and facilitates the
management of risk by savers and investors.
•It channel saving into long-term assets that are more productive than short-term assets.

It facilitates portfolio diversification for savers and investors.

•It collect and processes information about investment projects.
•Financial systems collect and evaluate information more effectively and
less expensively than individual investors because of the economies of
scale enjoyed by financial intermediaries.
•Low financial development or distortions in the financial system increase
the cost of investment and thus retard economic growth.
• It allow individual small savers to access large investment
projects through the mechanism of fund pooling.
• Individual investors are usually too small to access the
benefits of indivisible large projects.
• Pooling done by financial intermediaries allow the small
investors to access this avenue.
• It help diversify risk for small investors. Large
projects carry large risks.
• It is difficult for small investors to invest in
large risky investment projects by themselves.
• Financial intermediaries allow them to pool
risks.
• They can form portfolios of large risky
investments.
• Long term projects require long term investment.
Most small investors cannot afford to invest in the
long term.
• This temporal gap is bridged by financial
intermediation.
• This process is called liquidity management.
 Domestic resource mobilization
• Domestic resource mobilization refers to the
generation of savings from domestic resources and
their allocation to socially productive investment.
• It includes the mobilization of human and financial
resources for investment.
• The public sector mobilizes domestic resources
through taxation and public revenue generation for
investment in social services and infrastructure
• The private sector mobilizes the savings of
households and firms through financial
intermediaries, which allocate these resources to
investment in productive activities.
• Thus, enhancing domestic resources in poor
countries involves deepening the fiscal capacity of
the state and improving the social rate of return to
public investments.
 Challenges associated with domestic revenue
mobilization
• A) Low Savings: lack of saving or not enough saving
are generated to facilitate the required investments.
• Low saving rate in Sub-Sahara Africa explains the
low level of economic activity in the region and
slow pace of growth.
• Other factors include very low level of financial
intermediation and credit on the continent and the
fact that over 40% of African savings are invested
outside Africa.
• B) Capital flight: capital flight remains the most
stumbling block to domestic resources
mobilization. Tax flights from developing
countries are estimated to be higher than
aggregate inflows from development assistance.
• It undermines social contracts and damages
good governance.
• C) Tax incentive and exemptions: tax incentives
defined as tax provision granted to a qualified
investment project that represents a favorable
deviation from the provision applicable to
investment projects in general.
• Tax incentives distort resource allocation leading
to some sub-optimal decisions and therefore
harmful to long term growth.
 Tax incentives are not the primary
determinants of the decision to invest. Most
investors base their investment decisions on
economic and commercial factors on one
hand and institutional and regulatory on the
other.
• D) “Paradox of plenty”:– a characteristic of
many mineral rich countries in Africa is that
countries with rich natural resources are often
the worst governed.
• Entire increase in tax revenue in these
countries came from natural resources taxes
such as income from production sharing,
royalties and corporate income tax from oil
and mining companies.
• E) “Pareto Principle” : There are on few tax
payers who contribute a bulk of the taxes.
• F) Weak Administrative systems and
organization capacities: there are weak
administrative systems, and poor quality data
as a result of widespread informal activities.
Limited reporting and low levels of education
in the general population and culture of non-
compliance.
• There is a challenge of organization capacity
and resourcing where staff of tax
• G) Other challenges: include high taxes which
encourage tax evasion and other loopholes that
undermine collection. Complex tax legislation,
difficult to understand by tax payer and
discretion on the part of the tax officials which
leads to corruption.
• Lack of political will to protect tax
administration from political incursions.
 Solution

• a) Broadening the existing tax base: It will be

necessary to find way to tax the informal sector.
• Improvement in Tax Administration Capacity: There
is a need to automate the business process and
procedures of tax administration in Africa.
• Tax administrations should be restructured to address
the issue of a large informal sector in economies.
• Tax officials should be trained in current
methods of auditing to be able to audit
multinational firms. Government should
provide adequate resources in terms of
salaries and wages, equipment and machinery
and a friendly work environment with which
tax official work.
• c) Rationalization of Tax Incentives: In the
light of globalization new considerations have
 Low cost infrastructure especially in the
transportation and communication sectors.
e) Strengthen Tax Policy: Tax policy design must take
the administrative dimension of taxation carefully
into account.
• There is a need for transparent and accountability
where public and civil society scrutiny tax . Tax
policies should ensure the predictability and equity
of taxes in order that it does not lead to
opportunistic tax avoidance and evasion.
Agriculture’s role in economic development

• Agriculture’s role in economic development is

crucial because people in poor countries make
their living from land.
• The leaders can improve the welfare of the
majority by raising farmer’s productivity in
growing food and cash crops.
• Improving the price they receive for those
crops
• Farmers in developing countries must produce
enough food to feed themselves and urban
population.
• As urban population increases, the productivity
of farmers also must increase. If productivity
does not rise and in the absence of food
imports, will affect economic growth.
• Agriculture sector provide factor inputs – labor
to industry and other modern sectors.
• Agriculture sector also can be a major source
of capital for modern economic growth.
• Farming sector is an important market for the
output of the modern sector.
 Self-sufficiency and dwindling world food
supplies
• Food self-sufficiency can take several different
meaning.
• Dependence on foreign trade is dangerous to a
country’s economic health, and dependence on
food imports.
• If a country is dependent on others for food, the
suppliers of that food are in a position to bring
the dependent country to its knees whenever it
suits the supplier countries’ purpose.
• Population growth is rapidly eating into the
world’s food surplus and countries relying on
food imports soon will be find themselves
paying very high prices to get what they need
from the world’s dwindling surplus.
 Land tenure and reform
Land tenure and land tenure relations-refer to
the way people own land and how they rent it to
others to use if they choose not to cultivate it
themselves.
The patterns that exist:
 Large-scale modern farming- refers to a large-
large crop or cattle raising that uses some
hired labor
 Plantation agriculture- a system in which a
piece of land is used to raise crop usually for
export.
 Family land or independent peasant
proprietors- own plot of land
 Tenancy a situation where an individual family
farms a piece of land owned by a landlord to
whom the farmer pay rent
 Sharing cropping is a form of tenancy in which
farmer shares the crop with the landlord
 Absentee landlords- tend to live in cities or
elsewhere
 Communal farming- individual and families
may farm plots on communal land , to which
they gain access by custom or by traditional
leaders.
 Tenure and incentive
 Land tenure system have main impact on
agriculture productivity.
 An individual proprietor who have well defined
exclusive and secure property rights to land
knows that increase effort or skill that lead to a
rise in output also improves income.
 This does not the same if the land is owned by
someone else and property rights for farmer
are not well defined and secure.
 Incentive under communal farming suffer in a
different way.
 Property rights in this case are not exclusive because
land is owned in common.
 Each individual family has an incentive to use the
land to the maximum but no one has an incentive to
maintain or improve the land because the benefits
of individual improvement efforts accrue to
everyone who uses the land – i.e. free rider problem
 Land reform
The reform of land tenure system takes many
forms:
 Reform of rent contracts- ensures the tenure
of a tenant farmer. Many tenants farm at the
will of the landlord and can removed easily.
Laws requiring long term contracts that restrict
the landlord’s right to remove a tenant can
improve the tenant’s willingness to maintain
and invest in the land
 Rent reduction- involves a ceiling on
percentage share of the crop that landlord can
demand as rent.
 Land to the tiller – government can pass a law
setting a ceiling on the number of acres an
individual can own and force individual to sell
all land over that limit. Or law reform can state
that only those who actually till the land can
own it, and all other land must be sold .
 Land to till without compensation- all land not
cultivated by its owner is confiscated and the
former landlord receive nothing in return.
 Land reform and productivity
 The impact of land reform on agriculture
productivity depends on what kind of system
is being reformed.
 Land reform has the great positive impact on
productivity where after reform property
rights is well defined and secure
 Mobilization of agricultural inputs
 Rural public works projects: mobilizing labor to create
rural capital (i.e. roads, irrigation systems, and other
rural infrastructure). In the off season, labor in the
rural sectors is unemployed or underemployed.
 Rural banking and Micro Credit-
 Extension Services
 Development of rural markets- rural marketing
network – specialization which depend on economies
of scale, low transport cost and acceptable risk.
• Measure to reduce both transport cost ( by
building roads) and risk ( by guaranteeing
prices).
• Remove middle traders – drive down the price
paid to the producer and drive up that
charged to the consumers
 The Role of Agriculture in Economic and Rural
Development

•Agriculture and employment based strategy requires three basic complementary elements:

•(a) accelerated output growth through technological, institutional and price incentives changes
designed to raise the productivity of small farmers

•,(b) rising domestic demand for agricultural output and

•( c) diversified nonagricultural, labor intensive rural development activities that directly and
indirectly support and are supported by the community
 Barriers to agricultural development

•Urban bias against agriculture takes many forms:

•-the holding down of agricultural prices to favor the industry / urban sector

•-the concentration of investment in industry

•-tax incentives and subsidies to industry

•-tariff and quote protection for industry, which raises the price of fertilizers,
seeds and equipment

•-greater spending in urban areas on education, training, housing, nutrition and

medical provision which all affect productivity and quality of life
 rural development

•The realization of agricultural and rural development can be achieved

through the following agricultural and rural development strategies
Land reform
• Land reform entails a redistribution of right of ownership or use of
land away from large landowners in favor of cultivators with limited
or no land holdings.
• It can take many forms: transfer of ownership to tenants who
already work the land to create family farms, rural cooperatives or
state farm
• Land-tenure tenure system also have a major impact on
agricultural productivity.

• An individual who has well-defined, exclusive and secure

rights to land knows that increased effort or skill that leads to
a rise in output also improve income. This does not the
same if the land is owned by someone else and property
rights are not well define and secure.
• Farm structures and tenure patterns must be adapted to the objectives
of increasing food production and promoting a wider distribution of
benefits of agrarian progress.

• Agricultural and rural development will benefit the majority of people

only if there is a joint effort between the government and all farmers.

• This can be done through the provision of secured tenure rights to

individual farmer. Thus the farmer will has an incentive of made
improvement in his or her farm.
Supportive Policies
• government must created support system that provide the necessary incentives, economic
opportunities and access to needed credit and inputs to enable small cultivators to expand
their output and raise their productivity.

• Changes in rural institutions that control production (banks, moneylenders, seed and fertilizer
distributors),

• Supporting government aid services (e.g. technical and educational extension services,
public credit agencies, storage and marketing facilities, rural transport and feeder roads),
Government pricing policies with regard to both inputs (e.g. removing factor- price distortion)
and output (paying market-value prices to farmers).
• Rural public works projects:
• credit cooperatives: Each farmer must save a small sum and
these sum are pooled, one or two farmers can borrow to buy
capital
• Extension services:
• credit cooperatives: Each farmer must save a small sum and these sum are
pooled, one or two farmers can borrow to buy capital

• Extension services: rapid progress in rural areas depends on the introduction of

new inputs and new techniques- provide the link between the research
laboratories and the rural population.

• Development of rural markets: rural marketing network has impact on

productivity in agriculture.

• , low-cost transport and acceptable risk

Integrated Development Objectives
• Rural development depend efforts to raise both farm and nonfarm
rural real incomes through job creation, rural industrialization and
the increased provision of education, health and nutrition, housing
and a variety of related social and welfare services.
A decreasing inequality in the distribution of rural incomes and economic
opportunities
• The capacity of the rural sector to sustain and accelerate the pace of
these improvements over time.
 Urbanization and Rural Migration
 

• Todaro Model of Migration

•The Todaro model assumes that people immigrate in response to urban-rural difference in
expected income rather than actual earnings.

•The migrants consider the various labour market opportunities available to them in the rural
and urban sectors and choose the one that maximize their expected gains from migration.

•Expected gains are measured by the difference in real incomes between rural and urban work
and the probability of a new migrant’s obtaining an urban job.

•The migrant compares their expected incomes for a given time horizon in the urban sector (the
difference between returns and costs of migration) with prevailing average rural incomes and
migrate if the former exceeds the later.
The worker would seek the higher paying urban job.
•However, this migration model assume full or near-full
employment.
•In the full employment environment the decision to migrate
can be based solely on the desire to secure the highest-paid
job.
•Simple economic theory would then indicate that such
migration should lead to a reduction in wage differentials
through the interaction of the forces of supply and demand
in areas of both emigration and immigration.
• 
•However, such analysis is not applicable to Third
World nations.
•These countries are beset by a chronic unemployment
problem so that migrant cannot expect to secure a high-
paying urban job immediately.
•As a result in deciding to migrate the individual must
balance the probabilities and risks of being unemployed
or under unemployed for period of time against the
positive urban-rural real income differential.
• 
 The Harris-Todaro Migration Model

Migration takes place until the expected urban wage WM is equated to the rural wage WA. The
probability of getting the favored job is simply the ratio of employment in manufacturing, L M,
to the total urban labor pool, LUS
WA=LM/LUS[W¯M]
where WA is agricultural income, LM is employment in manufacturing, LUS is total urban labor
pool, and WM is the urban minimum wage.
The curve qq’ indicates the agricultural wage at which the potential migrant is indifferent
about employment location.
So the equilibrium agricultural wage is WA and OMLA-OMLM are either unemployed or
underemployed in the city.
51
Assume two sectors, rural agriculture and urban
manufacturing.
The demand for labour (marginal product of
labour curve) in agriculture is given by the
negative slope line AA.
Labour demand in manufacturing is given by
MM. The total labour force is given by line
OAOM.
• In a neoclassical flexible wage, full employment
equilibrium wage would be at WA* = WM* with OA LA *
workers in agriculture and OM L M* workers employed in
urban manufacturing.
• All available workers are therefore employed.
• But what if urban wages are institutionally
determined at a level WMIN which is above WA*
• If there is no unemployment, OM LM workers would get
urban jobs and the rest OA LM would have to settle for rural
employment at wages OA WA** (below the free market level
of OA WA*)
 Thus, there is an urban-rural real wage gap of
WM IN – WA** with WIN institutional fixed. If
rural workers were free to migrate then despite
the availability of only OM LM jobs they are
willing to take their chances in the urban job
lottery. If their probability of securing one of
these jobs is expressed by the ratio of
employment in manufacturing, LM to the total
urban labour pool, LUS then expression
•The new unemployment equilibrium now occurs at
point Z, where the urban-rural actual wage gap is
WM IN- WAOALA workers are still in the agricultural
sector and OMLM of these workers have modern
sector jobs paying WMIN wages.

•The rest OMLA – OM LM are either unemployed or

engaged in low-income informal sector activities. This
explains the existence of urban unemployment.
 Policy implications

Reduce imbalance in urban-rural employment opportunities.

eliminating various capital subsidies and curtailing the growth of
urban wages through market-based pricing.
Wage subsidies and factor pricing can be counterproductive-
eliminate factor pricing distortions by suing correct price –
implementing wage subsidies
Indiscriminate educational expansion will lead tom further migration
and unemployment-
Program of integrated rural development should be encourage.
 Creating an appropriate rural-urban economic
balance – e.g. improve credit access, better
agricultural training, social investment in rural
areas, improving rural infrastructure.
 Expansion of small-scale, labor intensive
industries: can be done through government
investment and incentive and improve access
to credit.
Wage subsidies and factor pricing can be counterproductive-
eliminate factor pricing distortions by suing correct price –
implementing wage subsidies
Indiscriminate educational expansion will lead tom further
migration and unemployment-
Program of integrated rural development should be encourage.

High rate of urban unemployment

lower level of agricultural output