Finance and Economic Activities

Abstract

This paper reviews the roles and limits of finance in modern economies.

Finance improves the efficiency of resource allocations. It does this by first correcting market failures and second by making markets function better. Finance also contributes toward economic growth and development. Finance does this by making more efficient investments and faster technological progress possible.

Finance, when it malfunctions, can bring serious economic disasters. Because of the asymmetry of information inherent in financial transactions, and because of the ability of the most important segment of the financial industry to create credit, finance may break down under certain conditions. When finance breaks down, it can easily bring the entire economy into trouble because finance is so pervasive.

Finance can malfunction, too, when the policy environment surrounding the financial markets and systems are so ill-designed as to give them wrong incentives. Here, financial controls used by developing economies often turn out to be the real causes for the breakdown of finance. One of the key reasons why finance may malfunction has to do with poorly working corporate governance mechanisms. When mechanisms governing the behavior of financial institutions and markets, the lenders and the intermediators, do not work properly, the latter are very likely to malfunction. When financial markets and institutions malfunction, they can easily bring trouble to the real economy. When mechanisms governing the corporate sector, the investor-borrowers, do not work properly, the real sector could breakdown. And when the real sector breaks down, financial systems and markets could breakdown, too. The paper also compares different modes of corporate governance being used in Korea, Japan, and America.