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Using a person's budget to understand the balance of payments

AP.MACRO:
MEA‑4 (EU)
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MEA‑4.A (LO)
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MEA‑4.A.1 (EK)
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MEA‑4.A.2 (EK)
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MEA‑4.A.3 (EK)
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MEA‑4.A.4 (EK)
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MEA‑4.A.5 (EK)
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MEA‑4.A.6 (EK)
Just like a personal budget, the balance of payments uses the sources of funds and uses of funds to track the movement of money. In this article, we use a young wizard's budget to make the BOP more relatable.
To get a better understanding of the balance of payments accounts, let’s think of a single person’s sources of funds and uses of funds. We can summarize Harry’s budget for this month as shown in the table below:
Source of funds or use of fundsAmount
Income earned from selling copies of his book “Talking to snakes for fun and profit”+dollar sign, 1000
Income earned from owl consultancy services+dollar sign, 200
Money spent on dementor repellantminus, dollar sign, 1200
Money spent paying for investment adviceminus, dollar sign, 300
Payment from Ron to borrow Harry’s wandplus, dollar sign, 50
Allowance from Aunt Petuniaplus, dollar sign, 2
Harry’s balanceminus, dollar sign, 248
Uh oh! Harry ran a little short this month!
Suppose there was one more thing that Harry hasn’t included yet: he also loaned Lucius dollar sign, 70. That means he also has a financial asset in the form of an I.O.U. from Lucius, but also dollar sign, 70 less money available to him. That means Harry has a total shortfall of cash of dollar sign, 248, plus, dollar sign, 70, equals, dollar sign, 318. As usual, his friend Hermione bails him out of trouble by loaning him dollar sign, 318.
Harry’s loan to Lucius and his loan from Hermione are different from the transactions in his budget because the dollar sign, 318 loan and the dollar sign, 70 loan both created liabilities for someone. So, let’s keep track of the transactions that created a liability in a separate balance sheet:
Source of funds or use of fundsAmount
Loan to Luciusminus, dollar sign, 70 (it is negative because this money left his possession)
Loan from Hermioneplus, dollar sign, 318 (it is positive because this money came into his possession)
Harry’s budget is his current account that summarizes all transactions that have not created liabilities. The transactions that created liabilities are his capital and financial account because those I.O.U. ’s eventually will need to be repaid.
We can summarize these in the table below:
Source of funds or use of fundsAmount
Income earned from selling copies of his book “Talking to snakes for fun and profit”start color #6495ed, plus, dollar sign, 1000, end color #6495ed
Income earned from owl consultancy servicesstart color #6495ed, plus, dollar sign, 200, end color #6495ed
Money spent on dementor repellantstart color #6495ed, minus, dollar sign, 1200, end color #6495ed
Money spent paying for investment advicestart color #6495ed, minus, dollar sign, 300, end color #6495ed
Wand rentstart color #6495ed, plus, dollar sign, 50, end color #6495ed
Allowance from Aunt Petunia:start color #6495ed, plus, dollar sign, 2, end color #6495ed
Harry’s current account balance
Outflow of money loanedstart color #ffa500, minus, dollar sign, 70, end color #ffa500
Inflow of money borrowed from Hermionestart color #ffa500, dollar sign, 318, end color #ffa500
Harry’s Capital and Financial Account balancestart color #ffa500, dollar sign, minus, 70, plus, dollar sign, plus, 318, equals, dollar sign, plus, 248, end color #ffa500
We can relate a country’s balance of payments account to the scenario we described above. The table below shows entries for the nation of Panem that are comparable to each of the entries on Harry’s Balance sheet:
Harry's source of funds or use of fundsHarry's AmountPanem's amount (in billions)Panem's category of BOP
Income earned from selling copies of his book “Talking to snakes for fun and profit”start color #ffa500, plus, dollar sign, 1000, end color #ffa500start color #df0030, plus, dollar sign, 1000, end color #df0030Goods exports
Money spent on dementor repellantstart color #ffa500, minus, dollar sign, 1200, end color #ffa500start color #df0030, minus, dollar sign, 1200, end color #df0030Goods imports
Balance on goods$1000$1200=$200\begin{aligned}&\$1000-\$1200\\\\&=-\$200\end{aligned}$1000$1200=$200\begin{aligned}&\$1000-\$1200\\\\&=-\$200\end{aligned}Balance on goods
Money spent paying for investment advicestart color #ffa500, minus, dollar sign, 300, end color #ffa500start color #df0030, minus, dollar sign, 300, end color #df0030Service imports
Income earned from owl consultancy servicesstart color #ffa500, plus, dollar sign, 200, end color #ffa500start color #df0030, plus, dollar sign, 200, end color #df0030Service exports
Balance on services$300+$200=$100\begin{aligned}&-\$300+\$200\\\\&=-\$100\end{aligned}$300+$200=$100\begin{aligned}&-\$300+\$200\\\\&=-\$100\end{aligned}Balance on services
Wand rentstart color #ffa500, plus, dollar sign, 50, end color #ffa500start color #df0030, plus, dollar sign, 50, end color #df0030Net investment income (also called factor income)
Allowance from Aunt Petuniastart color #ffa500, plus, dollar sign, 2, end color #ffa500start color #df0030, plus, dollar sign, 2, end color #df0030Transfers and remittances
Harry’s current account balance($200)+($100)+$50+$2=($248)\begin{aligned}(-&\$200)\\\\ + (-&\$100)\\\\ +&\$50\\\\+ &\$2\\\\=(-&\$248)\end{aligned}($200)+($100)+$50+$2=($248)\begin{aligned}(-&\$200)\\\\ + (-&\$100)\\\\ +&\$50\\\\+ &\$2\\\\=(-&\$248)\end{aligned}Panem’s current account balance
Outflow of money loanedstart color #6495ed, minus, dollar sign, 70, end color #6495edstart color #9d38bd, minus, dollar sign, 70, end color #9d38bdOutflow of foreign assets from Panem
Inflow of money borrowed from Hermionestart color #6495ed, dollar sign, 318, end color #6495edstart color #9d38bd, plus, dollar sign, 318, end color #9d38bdInflow of foreign assets to Panem
Harry's capital and financial account balance$70+$318=$248\begin{aligned}-&\$70 \\\\+ &\$318\\\\=&\$248\end{aligned}$70+$318=$248\begin{aligned}-&\$70 \\\\+ &\$318\\\\=&\$248\end{aligned}Panem’s capital and financial account balance
Balance of paymentsCA+CFA=$248+$248=$0\begin{aligned} &CA+CFA\\\\& =-\$248 + \$248\\\\&=\$0\end{aligned}CA+CFA=$248+$248=$0\begin{aligned} &CA+CFA\\\\& =\small -\$248 + \$248\\\\&=\$0\end{aligned}Balance of payments

Want to join the conversation?

  • duskpin ultimate style avatar for user Mischa Riedo
    This question might be rather stupid but how do we account for transactions that are made with previously saved money? Meaning we don't get the money to transact (current account) from a loan (capital account) but from money we already have?
    (14 votes)
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    • leafers ultimate style avatar for user Tony Zheng
      If Harry used up $318 of his own wealth instead of borrowing it, then there will be a transfer of money from Harry to other people. But money is a financial asset! So this is a transfer of a financial asset from a country (Harry) to another country (everyone else), which increases the capital account.
      (2 votes)
  • duskpin ultimate style avatar for user P A
    How does a surplus in Financial Accts help offset a current account deficit? Since, a surplus in Financial Accts means you took out loans that you have to repay later, doesn't that just increase our overall deficit in the long run?
    (2 votes)
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  • blobby green style avatar for user Tracy,C
    no question
    (1 vote)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user royshreshtha1997
    can we have a trade deficit balance despite surplus current account balance?
    (1 vote)
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  • blobby green style avatar for user Anusree Chakraborty
    If an asset is paid off, like say rent is given, that would fall in current account right but then why would it need to be again repaid
    What i mean is that Hermione helped Harry by giving him money but what do countries do
    or lets rephrase
    do countries have to work to balance the accounts or does it happen automatically
    (0 votes)
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  • female robot grace style avatar for user Katie E Miller
    so sal was on a harry potter kick good to know little bro might be happier than me because i am not that big of a potterhead i know a little dit were as my little bro is a big time potterhead
    side note wouldn't be in pounds not dollars everyone in the harry potter series english like from england becuase she as hell dont sound american they have a english accsent and considering they are kids they would have to pick it from there friend or parents
    (0 votes)
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