Fund Flow from Household
Now that we have understood the basics of fund flow or Financial Accounts of the US let us study
- the fund flow from each sector
- the forces that cause the demand or supply curve to shift and
- their impact on interest or exchange rates
Remember to simplify our understanding we assume a single market for borrowing and lending and a single interest rate – the price paid or received for borrowing and lending.
Flow of Funds from Households
Even though the flow of funds from households does not affect foreign exchange directly, it does impact interest rates. The main reasons household’s borrow (uses of funds) is to finance investments in housing, consumer durables and education. Household savings result in lending (sources of funds).
Savings leak into the capital markets in the way of deposits, bonds, stocks and other financial investments. Firms borrow from the capital markets to make investments in short term and long term capital expenditures. To determine what factors cause the behaviour of household borrowing or lending to change we need to study factors such as â€“ income levels, demographics, taxes, and availability of credit.
Factors that Impact Household Borrowing and Lending
The higher the income levels or confidence levels on the economy household’s have on the economic situation the higher will be their spending and borrowing, lower their savings and investments.
Demographics also play a part. The higher the ageing population in a country as a percentage of the total population the net savings fall since the older population ends up eating into their savings. A younger population would save a part of their income as investments.
Taxes can have a powerful effect on borrowing or lending for households. Taxes such as deductibles on mortgage interest expense can provide an incentive for the user to take on a mortgage despite having funds and using the funds to invest in say fixed income funds. So for example it may make no sense to take a home loan and 15% and invest in deposits at 8%. However if you can reduce your tax liability by more than 7% by claiming deductibles than parking your money in deposits at a lower rate and paying a higher rate on a mortgage starts to make sense.
The availability of credit – if credit is made easily available households will borrow more now and save less. If credit is not easily available then households will start saving for investing in a home
Shifts in the Demand and Supply Curve
If households become less willing to borrow the demand curve shifts to the left downwards. A shift in the demand curve to the left implies that borrowers will be willing to borrow less at any given level of interest rates.
We also see that the equilibrium interest rate falls when the demand curve shifts left. In our oversimplified scenario we see that a shift in the behaviour of households causes a shift in the demand curve, which in turn causes a fall in the equilibrium interest rate. If the over interest rate in the economy falls the return on investment in the funds market also falls making the funds market not the same level of attractiveness as before.
Next we study the flow of funds from firms.