The national income accounts do not tell anything about monetary or financial transactions whereby one sector places its savings at the disposal of the other sectors of the economy by means of loans, capital transfers, etc..
In fact, the national income accounts do not take into consideration the financial dimensions of economic activity and they describe product accounts as if they are operated through barter. The flow of funds accounts are meant to supplement national income and product accounts. The flow of funds accounts were developed by Prof. Morris Copeland’ in 1952 to overcome the weaknesses of national income accounting.
The flow of funds accounts list the sources of all funds received and the uses to which they are put within the economy. They show the financial transactions among different sectors of the economy and the link between saving and investment aggregates with lending and borrowing by them.
The account for each sector reveals all the sources of funds whether from income or borrowing and all the uses to which they are put whether for spending or lending. This way of looking at financial transactions in their entirety has come to be known as the flow of funds approach or of sources and uses of funds.
In the flow of funds accounts, all changes in assets are recorded as uses and all changes in liabilities are recorded as sources. Uses of funds are increases in assets if positive or decreases in assets if negative. They refer to capital expenditures or real investment spending which involve the purchase of real assets.
Sources of funds are increases in liabilities or net worth or saving if positive, and repayment of debt or dissaving if negative. Net worth is equal to a sector’s total assets minus its total liabilities. Therefore a change in net worth equals any change in total assets less any change in total liabilities.
Flow of Funds Matrix
The flow of funds accounting system is presented in the form of a matrix by placing sources and uses of funds statements of different sectors side by side. It is an interlocking self-contained system that reveals financial relationships among all sectors of the economy.
For the economy as a whole, total liabilities must equal total financial assets, although for any one sector its liabilities may not equal its financial assets. The consolidated net worth of an economy is consequently identical to the value of its real assets. This implies that saving must equal investment in an economy. Any single sector may save more than it invests or invest more than it saves. But the economy-wise total of saving must equal investment.
Table 9 presents the flow of funds matrix of an economy. For simplicity, we take the flow of funds accounts matrix of an economy divided into four sectors: households, nonfinancial corporations, financial institutions, and the government. These institutional sectors are shown in columns and various types of transactions in rows.
The flow of funds accounts are beset with a number of problems which are discussed as under:
- The flow of funds accounts are more complicated than the national income accounts because they involve the aggregation of a large number of sectors with their very detailed financial transactions.
- There is the problem of valuation of assets. Many assets, claims and obligations have no fixed value. It, therefore, becomes difficult to have their correct valuation.
- The problem of inclusion of non-reproducible real assets arises in the flow of funds accounts. Economists have not been able to decide as to the type of reproducible assets which may be included in flow of funds accounts.
- Similarly, economists have failed to decide about the inclusion of human wealth in flow of funds accounts.
Despite these problems, the flow of funds accounts supplements the national income accounts and help in understanding social accounts of an economy.
The flow of funds accounts present a comprehensive and systematic analysis of the financial transactions of the economy.
- The flow of funds accounts is superior to the national income accounts. Even though the latter are fairly comprehensive, yet they do not reveal the financial transactions of the economy which the flow of funds accounts do.
- They provide a useful framework for studying the behaviour of individual financial institutions of the economy.
- According of Prof. Goldsmith, they bring “the various financial activities of an economy into explicit statistical relationships with one another and with data on the nonfinancial activities that generate income and production.”
- They trace the financial flows that interact with and influence the real saving-investment process. They record the various financial transactions underlying saving and investment.
- They are essential raw materials for any comprehensive analysis of capital market behaviour. They help to identify the role of financial institutions in the generation of income, saving and expenditure, and the influence of economic activity on financial markets.
- The flow of funds accounts show how the government finances its deficit and surplus budget and acquires financial assets.
- They also show the results of transactions in government and corporate securities,, net increase in deposits and foreign assets in the economy.
- The flow of funds accounts help in analysing the impact of monetary policies on the economy as to whether they bring stability or instability or economic fluctuations.