In Parts 2–5 of this book, we have taken the domestic financial system for granted. The model of Part 2, the analysis of public-sector solvency in Part 3, and the discussions of monetary institutions in Part 4 and of exchange rate policy in Part 5 all assumed – explicitly or implicitly – 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 policy makers in emerging and developing economies, and macroeconomic performance in such 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.