Flow of Funds (FOF) - Meaning, Purpose & How It Works

What Is Flow of Funds (FOF)?

Flow of Funds (FOF) are financial accounts that trace the inflow and outflow of funds between sectors in an economy. This happens because money keeps revolving between sectors wherein the surplus from one sector is parked with another sector through financial vehicles such as loans or capital transfers. In India, the RBI collects this data and analyses it. The Flow of Funds account was developed by American economist Prof. Morris Copeland in 1952 to supplement the national income accounts.

The flow of funds accounts provide a comprehensive record of the financial transactions between different sectors of the economy, including the sources of all funds received and the respective uses of those funds. This approach is commonly referred to as the flow of funds or sources and uses of funds.

Each account of each sector details all sources of funds, be it from income or borrowing, and the funds’ uses, whether for expenditure or lending. Changes in assets are listed as uses, whereas changes in liabilities are listed as sources.

An increase in assets is considered as the use of funds (positive value under uses). Similarly, a decrease in assets is synonymous with the use of funds (negative value under uses). This type of spending typically involves the purchase of real assets or capital expenditures.

On the other hand, sources of funds can be an increase in liabilities or net worth (positive source of funds). Conversely, repayment of debt or dissaving is considered a negative source of funds.

Flow of Funds Example Explained

The following table shows the flow of funds between sectors in the financial year 2020-21 as published by the RBI:

As you can see in the above table, the Flow Of Funds is represented as a matrix with six major economic sectors:

• Household sector

• Financial Institutions

• Non-financial Corporations

• Government

• Savings & Investment

• Rest of the World (Foreign sector)

Understanding Flow of Funds Accounts

As you just saw in the above example, FOF is represented as a matric wherein sources and uses are placed in adjacent columns under each sector. Since a sector can lend to itself or borrow from itself, it will always show 0 under uses and sources when the rows and columns of the same sector meet.

FOF accounts use the concept of ‘double book-keeping’ which is nothing but the tracking of asset and liability changes in all the listed sectors. In order to easily grasp the concept of FOF, you should remember that the ‘Uses’ are basically expenses and lending, whereas the ‘Sources’ are all income and borrowings in that sector. This is why the sources are associated with changes in assets, whereas the uses are associated with changes in liabilities.

The FOF data is gathered and compared against that of the previous year in order to gauge whether the economic health of the nation has improved or declined. FOF data is also used by governments and policymakers to strategize the monetary policies.

Advantages and Disadvantages of Flow of Funds (FOF)

Advantages

• FOF accounts are more comprehensive than national income accounts because they reveal financial transactions that the latter does not.
• They offer a useful framework for examining the monetary exchanges of individual financial institutions within an economy.
• FOF accounts are crucial components for any comprehensive analysis of capital market behaviour. They help to identify the role of financial institutions in generating income, saving, and expenditure, and the impact of economic activity on financial markets.
• FOF accounts also illustrate how the government finances its budget, deficit and surplus. It also throws light on how it goes about acquiring financial assets.
• FOF accounts reveal the outcomes of transactions in government & corporate securities, net increases in deposits and foreign assets in the economy.
• FOF accounts assist in analysing the impact of monetary policies on the economy to determine if they bring stability, instability, or economic fluctuations.

• FOF accounts are more complex than national income accounts because they involve combining many sectors with their detailed financial transactions.

• The problem of valuation of assets is present in FOF accounts because some assets, claims, and obligations do not have a fixed value, making it hard to value them correctly.
• There is a challenge with including non-reproducible real assets in FOF accounts. Economists cannot agree on which reproducible assets should be included in the accounts.
• Economists are also uncertain about including human wealth in FOF accounts.

In conclusion, Flow of Funds (FOF) accounts are an essential tool for understanding the complex financial interactions that occur within an economy. By providing a comprehensive view of the flow of funds within an economy, they help us understand how money and resources are allocated and provide insights into how we can promote sustainable economic growth and stability.