Flow of Funds – OverviewÂ
The Flow of funds or the Financial Accounts of the US is an account prepared by the Federal Reserve Bank that documents the flow of borrowing and lending in the economy.Â Borrowers and Lenders are divided into four sectors â€“ households, businessesÂ (non financial), governments and the Rest of the world or basically foreigners.
Financial Accounts of the US
The statements show the total lending or sources of funds, borrowing or uses of funds, net lending and net borrowing.
Lets understand how the sources and uses of funds increase or decrease in these sectors
Total Lending is the net acquisition of assets. For example if a household invests 100,000 in bonds, 10,000 in time deposits at the start of the year making your financial assets 110,000 and by the end of the year the investment in bonds increases to 110,000 and time deposits decreases to 5000 making your investments by the end of the year at 115,000; the household’sÂ lending in that year is 5000.
Similarly total borrowing is the increase of financial liabilities over the year. Assume another household starts with mortgages of 100,000 in the year, however by the end of the year a new car loan of 10,000 is taken and 5000 of the mortgage is retired. The borrowing of the household over the year is now 105,000 â€“ 100,000 = 5000
Net Lending and Net borrowing is the difference between Total lending and Total borrowing. If the total lending is greater then the sector is a net lender. If the total borrowing is greater the sector is a net borrower.
There are multiple markets for interest rates such as the loans market, bond market, mortgage markets, automobile loans market and so on. If we were to take each market separately to determine the effect of interest rates on demand and supply of funds flow into that market it would be very time consuming and unnecessarily detailed for our purpose.
Lets consider the flow of funds into and out of the capital markets as a single market calling it the funds market. Next lets study the effects of interest rates on the demand and supply of these funds and visa versa.
Demand and Supply Curve
The Demand Curve â€“ The demand curve is a downward sloping line since higher the rates less the demand for funds. Borrowers find it too expensive to borrow at these rates and would increase their borrowings at lower levels. The demand curve is therefore negative sloping.
The Supply curve â€“ slopes upward since higher the interest rates, more the willingness of lenders to lend. Lower the rates lower the supply of loanable funds.
Shifts in the Supply and Demand Curve
Both the supply and demand curve depict the behaviour of sources and users of funds. The number of borrowers must equal the number of lenders and the rate at which that happens is the equilibrium rate of interest. The equilibrium rate changes if there is a shift in either the demand curve or supply curve.
These shifts in the demand or supply curve are caused by the various factors that affect the behaviour of borrowers or lenders. For example we have looked at the consumer confidence economic indicator which is an index that measures the changes in consumer confidence in the economy.
When households are less confidence about the economy their willingness to borrow decreases, they spend less, save more and therefore lend more. This causes a shift in the demand curve to the left.
Likewise the behaviour of all the sectors that supply and demand funds cause shifts in the demand and supply curve, which in turn result in the fluctuations of interest rates.
To understand these fluctuations in interest rates we need to understand the forces that cause the behaviours to change for each sector. Lets look at that next.
Next – Flow of Funds – Households