Flow of Funds: Implications for Research on Financial Sector Development and the Real Economy

This paper provides a selective survey of the leading theoretical and empirical issues surrounding the flow of funds:

• Meaning and origin;
• Problems of construction;
• Key issues involved in financial modeling.

The paper:

• Argues that there is an intimate connection between the flow of funds, interest rate and asset price determination, and hence, incomes and expenditures in an economy;
• The paper also explores the reasons for lack of success at empirical flow of funds modeling and proposes promising research ideas (PRIs) for future research on the relationship between financial sector development and the real economy, especially in order to identify effective financial sector policies for promoting poverty-reducing economic growth in low-income developing countries.

These PRIs include:

• Incorporation of the recent advances in constructing and estimating flow of funds in order to develop a flow of funds framework that would be suitable for studying the relationship between financial sector development and the real economy in a low-income developing country such as India or Kenya;
• The way in which the flow of funds framework may be applied by policy makers for the analysis of financial problems in developing countries;
• Usage of the flow of funds models to investigate the pattern of intersectoral financial flows in a sample of low-income countries in South Asia and sub-Saharan Africa, focusing in particular on:
  • Household choice (including consumption, saving and investment),
  • Corporate sector (investment and financing),
  • Banks (intermediation, debt and equity financing),
  • Government sector (taxation and spending),
  • Overseas sector (debt, aid and foreign direct investment).