What is the flow of funds?

The flow of funds is the financial accounts of the nation, which monitor and control the cash flow among various sectors or industries, or markets. Central banks use these flow of funds statements to acquire macroeconomic data, to publish cash inflow and cash outflow statements of the nation. This flow of funds system is utilized to identify economic activity and changes in the economy. It is used by Federal Reserve to determine the Gross Domestic Product (GDP) of the nation and to implement monetary policy and fiscal policies.

Structure of flow of funds

The flow of fund analysis is a system of interconnected balance sheets for a nation. Under the flow of fund analysis, two types of balance sheets are prepared to show the breakdown of assets and liabilities of the sectors. Flow-of-funds accounts are prepared by Federal Reserve Bank using a double-entry bookkeeping system. Federal Reserve Bank prepares the flow of funds analysis on a quarterly basis and publishes the data. The following are the two types of balance sheets:

• A balance sheet is prepared to show the assets and liabilities of economic sectors.
• A balance sheet is prepared to show the supply and detain of financial assets of economic sectors.

The flow of fund matrix

The flow of funds account is prepared in the form of a matrix that discloses the financial relationship of all the economic sectors. In this matrix, the assets and liabilities of the sectors are listed. Sectors are listed in the columns of the matrix and fund flows from different sources are listed in the rows. Every column shows the individual sector along with its value of assets, debts, savings, investments, and net income. Total savings and total investments should be equal in the flow of funds accounts. But the savings and investments of the individual sectors should not be equal because sectors may have higher savings than their investments and vice versa. Even though sector-wise assets and liabilities are not tallied, the assets and liabilities of the total economy should be equal.

Sectors of the flow of funds

The flow of funds statement covers various economic sectors or markets together and classifies them into financial and non-financial sectors. This sector-wise statement helps economists to understand the cash inflow and cash outflow among economic sectors. The sectorial-based examination is used to identify the movement of assets and debts within sectors. The input-output analysis also represents the relationship of the economic sectors by using macroeconomic analysis. The economic sectors are divided into two. The following are the two types of economic sectors:

• Non-financial sectors
• Financial sectors

Non-financial sectors

Non-financial sectors include institutional sectors. Non-financial sectors in the economy are the legal corporations and market producers whose primary operation is the manufacturing of market goods and rendering non-financial services. The following sectors are covered in the economics non-financial sectors:

• Household sectors which include not for profit entities
• Private non-financial corporations
• Incorporated and unincorporated organizations
• Government sectors which include federal, state, and local government
• Foreign corporations

Financial sectors

The financial sector is an important part of the nation’s economy which provides financial services to people. The financial sector consists of banks, investment companies, insurance companies, and real estate entities. Financial sectors support the economy financially. Entities under financial sectors generate income from loans, advances, investments, and insurances. When the interest rate is low, people and organizations should seek funds for working capital and investment. When people and organizations borrow more, financial sectors gain income in the form of interest. If financial sectors are weak, it will affect the general customer and the nation’s economy. The following sectors are covered under financial sectors:

• Federal Reserve system
• Insurance companies that cover life insurance and all other types of insurances
• Investment companies which include pension fund and mutual fund
• Real estate firms
• Financial instruments asset types include securities from markets, bonds, mutual fund shares, money markets, loans, and advances from banks and other financial institutions

Importance of flow of funds

The flow of funds statement helps to evaluate the performance of the economy and represents the nation’s financial condition. This statement defines the flow of funds of every individual sector and represents the individual sector’s assets and liabilities. The following are the importance of the flow of funds:

Higher than the income statement

The income statement reflects the net income and loss of the economy. But the flow of funds statement represents the movement of all assets and debt balances and monitors the cash inflows and cash outflows of every individual sector.

Able to analyze the individual sector's activity

Flow-of-funds accounts use a matrix in which the economic activity of each sector is listed. Economists should utilize the flow of funds statement to make economic decisions and to ensure the stable growth of the nation.

Trace the financial transactions of the country

In the flow of funds statement, all the financial movements of the country are recorded. The assets and liabilities of the individual sector are identified using the flow of funds accounts. The flow of funds accounts reflects the savings, investments, debts, and advances of the nation. Money supply and demand are determined with the help of the flow of the fund analysis.

Limitations of the flow of funds

Even though the advantages of the flow of funds accounts are vast, it has some limitations. Following are the limitations of the flow of funds accounts:

More complicated than income statement

The flow of funds analysis of the economy is considered more complicated than income statements of the nation because it shows the cash movements among the sectors. It also reveals the savings, investments, debts, assets, and net worth of every sector. The flow of funds statement cannot be presented alone. The income statement and balance sheet must be presented along with it for better understanding and interpretation.

Non-inclusion of the wealth of the human

Human wealth is not included in the flow of funds accounts. Economists have failed to decide whether to add the wealth of individuals to the flow of funds accounts.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate courses, and postgraduate courses, especially for

• Bachelors in Business Administration (Finance)
• Masters in Business Administration (Finance)
• Masters in Business Administration (Investment Management)
• Bachelor of Arts in Economics
• Master of Arts in Economics

Practical Problems