In Parts 2 and 3 of this book we took the domestic financial system for granted. The model of Part 2 and the analysis of public sector solvency in Part 3 assumed a domestic financial structure in which financial assets consisted of cash and securities that were traded in open markets. There were no specialized financial institutions as such, and in particular there were no banks.

But management of the domestic financial system is actually one of the key challenges facing policymakers in emerging economies. Macroeconomic performance in emerging economies depends critically on the state of the financial system. The functioning of the financial system strongly affects the economy's long-run growth performance, as well as its short-run macroeconomic stability. Distortions in the domestic financial sector can present serious obstacles to long-run growth by impairing both capital accumulation and growth in total factor productivity. On the other hand, financial sector weaknesses can themselves be the source of macroeconomic instability or can serve to propagate and magnify macroeconomic shocks arising elsewhere in the economy.

Part 4 takes up the role of the financial system, as well as of policies directed to the financial system. We will begin here by examining how the financial system can affect economic welfare and long-run growth. The perspective to be adopted is that, in a world of imperfect information, financial intermediation is an economic activity that is productive in a very real sense, that is, it uses scarce productive inputs to produce valuable outputs.