The Flow of Funds in a Financial System

The economy of any nation can be viewed from the point of view of fund flow. This is a unique way to view the economy, which until now has only been viewed as a sum of all the sectors in it.

In simple words, this means that the economy as a whole is a combination of several smaller units. These smaller units are constantly transferring funds to one another. As a result, some units in the economy have a surplus, whereas others are running a deficit.

The transfer of funds is basically a map that aids in developing a clearer picture of the economic relationships which prevail in the economy. A better understanding of the economy can be obtained by using fund flow as a tool for analysis. This can be done by following the steps given below:

1. Firstly, it is important to group together homogenous economic entities and form one sector.

   For instance, the economy can be viewed as a combination of the household sector, the business sector, the financial sector, the government sector, and the financial institution sector.

   In some countries, the international sector may be listed down separately. This needs to be done only if international investments are significant. Otherwise, they can be added to the government, business, or financial sector depending upon who is conducting the transactions.

   It is important not to create too many or too few sectors. The number of sectors created should be enough to aid analysis, but no so much that it unnecessarily creates complications.

2. Secondly, the profit and loss account and balance sheet for each sector need to be drawn up. This means that the flow of money through each of these sectors should be mapped using the sources and application of funds principles which are used in accounting.

   This may not be an easy task since the financial details related to private and household sectors are not easily available. Details pertaining to the government and the financial sector are published, whereas those related to other sectors are not.

3. The next step is to classify the sector as having a surplus or being deficient. In some cases, the sectors will be balanced. This means that the amount of money flowing into the sector will be exactly equal to the amount of money flowing out of the sector.

   It needs to be understood that at the end of the exercise, the sum total of all surpluses and deficits should be zero. This will always be the case unless there is a lot of money flowing into or out of the entire economy. If that is the case, then, as mentioned above, the international sector should be considered to be a separate sector within the economy.

The purpose of the exercise is to understand which sectors of the economy are funding, which other sectors of the economy. Once the cash cows of the economy are identified, it is possible for the government to create schemes that help that sector grow even further.

Using this fund flow exercise, it is possible to create an entire map of the various transactions happening in the economy from a macro point of view.

This exercise enables the understanding of how financial systems play an important role in the economy. This is because all the money which is routed from any surplus sector ends up being in the hands of a deficient sector after using the financial system.

From the point of view of the government or the regulator, it is important to identify the paths between surplus and deficient sector so that that the bridge connecting the two can be built as soon as possible.

Using Fund Flows to Understand The International Financial System

The fund flow approach, which can be used to understand the flow of funds within an economy, can also be used to understand the flow of funds between different economies.

In the international economy, there are deficit countries that are in need of funds from other countries. Also, there are surplus countries that have additional funds to lend out to other countries.

The international financial system also has to be set up in such a way that it becomes easier for the deficient countries to receive funds from countries that have a surplus.

The bottom line is that fund flows within an economy provide important clues about how the financial system operates in that country. It also provides important clues about the gaps that exist in the financial system and provides a roadmap for the steps which need to be taken to fill that gap.