This paper analyzes the role of the financial system for economic growth and stability, and addresses a number of core policy issues for financial sector reforms in emerging economies. The role of finance is studied in the context of a circuit model with interacting rational, forward- looking, and heterogeneous agents. Finance is shown to essentially complement the price system in coordinating decentralized intertemporal resource allocation choices from agents operating under limited information and incomplete trust. The paper also discusses the links between finance and incentives to efficiency and stability in a circuit context. It assesses the implications for financial sector. | Circuit theory of finance and the role of incentives in financial sector reform by Biagio Bossone World Bank November 1998 Summary This paper analyzes the role of the financial system for economic growth and stability and addresses a number of core policy issues for financial sector reforms in emerging economies. The role of finance is studied in the context of a circuit model with interacting rational forwardlooking and heterogeneous agents. Finance is shown to essentially complement the price system in coordinating decentralized intertemporal resource allocation choices from agents operating under limited information and incomplete trust. The paper also discusses the links between finance and incentives to efficiency and stability in a circuit context. It assesses the implications for financial sector reform policies and identifies incentives and incentive-compatible institutions for financial sector reform strategies in emerging economies. The author is intellectually indebted to the work of Prof. Augusto Graziani in the field of monetary circuit theory. The author wishes to thank Jerry Caprio Stjin Claessens and Larry Promisel for their helpful comments on earlier drafts of the paper. He bears full responsibility for any remaining errors and for the opinions expressed in the text. The author is especially grateful to his wife Ornella for her invaluable support. For comments contact Biagio Bossone E-mail Bbossone@ tel. 202 473-3021 fax 202 522-2031. TABLE OF CONTENTS I. FINANCE IN A MARKET The circuit process of Assumptions and structure of the Structural implications of Efficiency and stability implications of CTF the role of Theoretical and methodological features of Finance growth and stability brief conceptualization and recent II. FINANCIAL SECTOR REFORMS IN EMERGING CTF and incentive-based financial sector .
