The Incorrect Hydraulic Model for Flow of Funds The Incorrect Hydraulic Model for Flow of Funds

Explaining Flow of Funds

The Incorrect 'Hydraulic Model' of Flows

The term 'flow of funds' seems to imply that funds are'flowing' in the economy through channels, like water.

This analogy is sometimes referred to as a 'hydraulic model' of economic activity.

The animation shows imaginary money 'flows' in a sector that is selling corporate bonds, buying corporate equities, and then reselling the equities.

Animated Diagram: Hydraulic Model for Flow of FundsThe 'Hydraulic Model' of a sector buying and selling stocks and bonds.

The 'Hydraulic Model' is misleading and wrong for several reasons:

The 'Flows' Misnomer

The flow of funds tables do not really show 'flows'.

Money is not 'flowing' at all.

The Federal Reserve tables do not show how much money moves or 'flows' from sector A to sector B per quarter or per year.

The circular flow in the diagram, showing a sector that is selling bonds and buying stocks, would be reversed for the counterparty sector that sells stocks and buys bonds.

This would means that a complete 'hydraulic' diagram including both buying and selling sectors would need to show 'money' flowing in both directions at the same time.

The imaginary 'hydraulic pressure' from the 'money flows' would therefore cancel out.

Prices are not driven by 'hydraulic pressure' of money flows, but rather by motivation of buyers and sellers, as stated in the Motivation Axiom.

It is important to understand why the 'hydraulic model' is incorrect, because analysts easily are trapped by faulty reasoning, assuming that 'money flows' exert pressure on prices.

For example:

Over the last generation, U.S. households have been net sellers of corporate equities. A careless analyst might conclude that 'money flowing out of stocks' would drag stock prices downwards. However, this did not happen. For the last twenty years of the 20th century, U.S. equity prices trended upwards.

Despite the unfortunate naming of the 'flow of funds accounts' , the hydraulic model is not appropriate for Capital Flow Analysis.

 

Before proceeding, check your progress:

Self-Test

For purposes of Capital Flow Analysis, the 'Hydraulic Model' is misleading because:
Choice 1 Money flows have high viscosity.
Choice 2 Money is trans-fungible.
Choice 3 'Money pressure' does not move prices.
Choice 4 Flows are clockwise, not counter-clockwise.
The National Flow of Funds Accounts are:
Choice 1 Represented by circular flow diagrams.
Choice 2 Inappropriatedly named.
Choice 3 Used to find money velocity.
Choice 4 Compiled by Standard & Poor's.
'Money flowing out of stocks' will:
Choice 1 Suck stock prices downwards.
Choice 2 Cause a whirlpool effect.
Choice 3 Sweep investors away in the current.
Choice 4 Shift stock ownership between sectors.

Learning Module: Capital Flow Analysis  Explaining Flow of Funds : continued >

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