# **III. Description of the Model**

# **JA The Flow-of-Funds Approach**

The basis of the RMSM-X is the Flow-of-Funds (FOF) framework, which neatly summarizes all incom. and financial transactions undertaken in a modem economy. This framework is well known, and we wil only concentrate on its basic features, specially in relation to the banking sector (Hlolsen [1989] provides a detailed overview to those unfamiliar with the FOF method). The FOF system represents a powerful tool of analysis because it describes the expenditure and financing of the various sectors of the economy, and the categories of market instruments used in all financial transactions. Such a system brings out explicitly important macro-economic accounting identities that aid in tile fortnulation of behavioral hypotheses, in the design and control of development plans, and in the design and checking of consistency of short-run financial programs.

The basic idea behind the FOF method is the description of economic activity as t'le interrelated expenditure and saving pitterns of economic "agents." In typical applications, the FOF is divided into five sectors: the Public Sector, the Private Sector, the Monetary Sector, the Foreign Sector (Balance of Payments), and the Producing Sector (National Accounts). The FOF approach considers these sectors as if they were iniependeiit economic agents. The structure of the FOF is then based on their budget constraints. That is, the FOF tracks down the sources and uses of income for these agents in the economy. A typical FOF system, including current and capital account flows, is shown in Table 1, with the rows representing the sources, and the columns the uses. We now describe the system in snore detail.

The FOF is divided into two parts, reflecting current and capital transactions. Tne first part registers the sources of funds, which consist of the receipts from the sale )f goods and services currently supplied and transfers; it also records the uses of these funds, such as the purchase of goods and services, and savings. The second part registers the receipts from the sale of financial claims, or the assumption of financial liabilities and the outlays on the acquisition of financial claims, or the repayments of financial liabilities. Thus, every agent will generate current income and expenditures, with savings being the difference between the two. The agent's savings and borrowing (accumulation of liabilities) are then us.d to finance its capital expenditures and accumulation of assets. For every agent, its budget constraint then may be represented as:

# **Sources of Funds =** Uses **of Funds**

# **Current Income = Current Expenditure +** Savings

# **Savings + Accumulation ot Liabilities = Capital Expenditures** + **Accumulation of Assets**

For example, in Table 1 in the current account the Public Sector receives direct tax and rmn-tax income from the Private and Monetary sectors, and net indirect taxes from the Producing sector. Also, the Public Sector may receive foreign grants, or other transfers from abroad. Income will then be used to pay interest on domestic and foreign debt, in transfers and subsidies, and in consumption and savings. Total current revenue should be equal to total current expenditures plus savings. In the capital accounts, the Public Sector will use its savings and borrowing from domestic and foreign sources to finance its capital expenditures. These are mainly investment and transfers to the monetary system in the form of capital inflows. An algebraic descripLion of all budget constraints is given in Appendix C.

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