The Role of Government in Influencing Financial Markets

The Role of Government in Influencing Financial Markets

Governments exert their influence over financial markets via laws, agency regulations, central bank activities, and tax policy decisions. An analyst must understand these influences to effectively manage portfolios.

Governments also engage in transfer payments to redistribute income among workers, retirees and other groups – these payments constitute government expenditures rather than purchases.

Interest Rates and Loanable Funds

Markets worry that an indebted government might, in their quest to meet budget deficit targets, select policies which risk fuelling inflation – for instance increasing public spending or monetising debt and restricting capital movements as ways of cutting interest rates.

Demand and supply for loanable funds determine the equilibrium interest rate, which ultimately decides how investments in real capital are distributed to firms producing products consumers want. External factors can alter either demand or supply curves and alter this process significantly.

Banks and investors are among the primary sources of loanable funds, offering loans or investing in interest-bearing assets like bonds or certificates of deposit. When investors expect low returns from business investments, demand curve for loanable funds shifts right and interest rates increase – this phenomenon is known as crowding out.

Deposit Insurance

Many believe deposit insurance increases confidence and decreases bank runs during economic crises, but my research shows otherwise. Deposit insurance creates a different incentive structure for administrative agencies when responding to crises; when its residual claimant is government agencies rather than private insurers, less incentive exists to price risks accurately and intervene appropriately during crises (Demirguc-Kunt and Kane 2002).

An effective deposit protection system must work to reinforce, not interfere with, market incentives for large and small depositors, borrowers, bank managers, economic policymakers and political leaders to behave responsibly. Furthermore, it should rest on a strong legal basis with clearly laid out property rights rules regarding closure of failed banks as well as political interference preventing. When these conditions are fulfilled then deposit insurance can help foster banking sector stability as well as total financial markets development.

Regulatory Role

While governments do not directly participate in financial markets, they regulate them through regulatory bodies like the Securities and Exchange Commission in the US that set trading rules and monitor adherence to these rules. Hearings may also take place and decisions issued.

Governments have traditionally attempted to control the financial system to meet their social-economic goals. With globalization and looser regulations on capital flows, however, their traditional role has diminished considerably in shaping financial markets.

Governments typically influence markets through interest rates, deposit insurance and fiscal policy measures. These actions aim to stabilize the financial system and create an environment conducive to job creation while stimulating economic growth. Price stability, sound public finances and balanced budgets all work toward this end – encouraging investment activity while simultaneously increasing overall liquidity in financial markets.

Financing Channels

Financial markets efficiently facilitate the flow of funds by connecting those with excess cash with those looking for it, creating a free market for securities and liquidity that promotes wealth accumulation and economic expansion.

Governments can interfere with financial markets in a number of ways. Subsidies and taxes may give certain industries an unfair competitive advantage while depriving others of necessary resources, thereby negatively impacting profits.

Monetary policy can also have a significant effect on the economy through credit channel mechanism. This indirect amplification channel of interest rate transmission primarily influences household spending on durable goods and firm investment decisions by altering intermediated credit availability, for instance bank credit is often seen as a substitute form of capital that reduces price (Groening, 1998). Working capital funding such as listed financing allows businesses to convert invoices into cash in order to prevent disruptions caused by short-term capital shortages in supply chains (Groening 1998).