Liberalisation of Financial system, Indian Financial System Video Lecture | Indian Financial System - B Com

so in this video I want to study the
effects that financial liberalisation
has some financial markets and I'm gonna
go over a paper from Brown Aventura of
last year so the question they ask is
what happens when countries liberalize
when countries open their borders to
financial transactions from abroad
well the conventional view has said that
this will lead to really good outcome
the country will receive a lot of
capital influence from abroad and this
will help the country insure against
aggregate risk and reduce volatility but
in reality this is not what I've seen in
the data when countries liberalize
sometimes we see domestic capital
flights and increases in volatility that
mean that domestic markets become more
fragile after the opening so why is this
the case well they argue that this
conventional view failed to anticipate
the effects that opening up would have
them deb enforcement and that some
countries would end up wanting to
discriminate against foreign investors
if the institutional framework is not to
solve it producing a very high risk of
default okay so imagine we have you know
two types of investors we have foreign
investors and domestic investors the
domestic guy is just maximizing his
lifetime utility and when the economy is
closed
he's just consuming a fraction of his
wages and he's saving the other the
savings of course going to capital when
he's old he consumes the returns that
that capital gives them of course as we
usually assume this wage is just gonna
be the marginal product of labor and the
interest rate on the capital is just
going to be the marginal product
thus in this closed economy we will end
up having um there's low of motion for
the capital stock which means that that
the country just saves a constant
fraction of of the of the country's
income now imagine that we liberalize
the financial markets and we open up the
economy that is we allow citizens to
domestic guys to participate in
international financial markets the
savings of the country are really high
we'll end up lending to the rest of the
world that means that we will be buying
the bonds that the foreigners issue and
we will receive a fixed rate that is
just equal to one the lending rate that
international financial markets require
but then there is the other case in
which we need money so what we can do is
we can borrow from abroad we issue some
bonds and we sell them to the foreigners
and that's how we finance ourselves now
if we borrow it ended up happening that
the rate at which we borrow is a little
higher than the rate we will be getting
if we lend it so why do we have to pay
more if we borrow money than what we
will receive if we were lending money
basically because there is a risk that
we are not solvent and that we we end up
defaulting you know if this wasn't true
if we always repay our debts both the
lending and and the borrowing rent will
be equal but since there is a
possibility that we default we have to
pay more if we want to get money now
imagine there are two cases on the one
hand governments can force and force
their citizens to pay back foreigners
and in the other case governments cannot
enforce and will not have citizens pay
back the debts to foreigners obviously
the higher the probability of
enforcement the lower the interest rate
we will have to pay
for borrowing money from abroad because
we will be seen as less risky and this
is why the borrowing rate takes just a
cyst form basically if the probability
that we will pay back the debts was was
1 then we will just be borrowing at a at
the same rate as the lending rate but in
today's the slightest chance that this
probability is less than 1 then we would
have to borrow at a higher interest rate
and this is where the quality of the
institutions of the country that is
borrowing starts to matter
imagine that with probability pi is very
good and always succeed in making debts
paid back and with probability 1 minus
pi this institutions fail and
governments are free to choose whether
they want to enforce or now enforce so
basically since defaulting not in
britain results in higher welfare for
the country whenever institution fails
there will be a default this simplifies
our analysis since the probability of
enforcement which is the probability
that institutions are good now countries
with dat institutions with low PI's will
need to pay a higher premium for
borrowing and this is why the higher the
PI the lower the borrowing rate I will
continue in the next video