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

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 funds | Amount |
---|---|

Income earned from selling copies of his book “Talking to snakes for fun and profit” | +$\$1000$ |

Income earned from owl consultancy services | +$\$200$ |

Money spent on dementor repellant | $-\$1200$ |

Money spent paying for investment advice | $-\$300$ |

Payment from Ron to borrow Harry’s wand | $+\$50$ |

Allowance from Aunt Petunia | $+\$2$ |

Harry’s balance | $-\$248$ |

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 $\$70$. That means he also has a financial asset in the form of an I.O.U. from Lucius, but also $\$70$ less money available to him. That means Harry has a total shortfall of cash of $\$248 + \$70=\$318$. As usual, his friend Hermione bails him out of trouble by loaning him $\$318$.

Harry’s loan to Lucius and his loan from Hermione are different from the transactions in his budget because the $\$318$ loan and the $\$70$ 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 funds | Amount |
---|---|

Loan to Lucius | $-\$70$ (it is negative because this money left his possession) |

Loan from Hermione | $+\$318$ (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 funds | Amount |
---|---|

Income earned from selling copies of his book “Talking to snakes for fun and profit” | $\blue{+\$1000}$ |

Income earned from owl consultancy services | $\blue{+\$200}$ |

Money spent on dementor repellant | $\blue{-\$1200}$ |

Money spent paying for investment advice | $\blue{-\$300}$ |

Wand rent | $\blue{+\$50}$ |

Allowance from Aunt Petunia: | $\blue{+\$2}$ |

Harry’s current account balance | |

Outflow of money loaned | $\orange{-\$70}$ |

Inflow of money borrowed from Hermione | $\orange{\$318}$ |

Harry’s Capital and Financial Account balance | $\orange{\$-70+\$+318=\$+248}$ |

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 funds | Harry's Amount | Panem's amount (in billions) | Panem's category of BOP |
---|---|---|---|

Income earned from selling copies of his book “Talking to snakes for fun and profit” | $\orange{+\$1000}$ | $\red {+\$1000}$ | Goods exports |

Money spent on dementor repellant | $\orange{-\$1200}$ | $\red{ -\$1200}$ | Goods imports |

Balance on goods | $\begin{aligned}&\$1000-\$1200\\\\&=-\$200\end{aligned}$ | $\begin{aligned}&\$1000-\$1200\\\\&=-\$200\end{aligned}$ | Balance on goods |

Money spent paying for investment advice | $\orange{-\$300}$ | $\red{-\$300}$ | Service imports |

Income earned from owl consultancy services | $\orange{+\$200}$ | $\red{+\$200}$ | Service exports |

Balance on services | $\begin{aligned}&-\$300+\$200\\\\&=-\$100\end{aligned}$ | $\begin{aligned}&-\$300+\$200\\\\&=-\$100\end{aligned}$ | Balance on services |

Wand rent | $\orange{ +\$50}$ | $\red{+\$50}$ | Net investment income (also called factor income) |

Allowance from Aunt Petunia | $\orange{+\$2}$ | $\red{+\$2}$ | Transfers and remittances |

Harry’s current account balance | $\begin{aligned}(-&\$200)\\\\ + (-&\$100)\\\\ +&\$50\\\\+ &\$2\\\\=(-&\$248)\end{aligned}$ | $\begin{aligned}(-&\$200)\\\\ + (-&\$100)\\\\ +&\$50\\\\+ &\$2\\\\=(-&\$248)\end{aligned}$ | Panem’s current account balance |

Outflow of money loaned | $\blue{-\$70}$ | $\purple{-\$70}$ | Outflow of foreign assets from Panem |

Inflow of money borrowed from Hermione | $\blue{\$318}$ | $\purple{+\$318}$ | Inflow of foreign assets to Panem |

Harry's capital and financial account balance | $\begin{aligned}-&\$70 \\\\+ &\$318\\\\=&\$248\end{aligned}$ | $\begin{aligned}-&\$70 \\\\+ &\$318\\\\=&\$248\end{aligned}$ | Panem’s capital and financial account balance |

Balance of payments | $\begin{aligned} &CA+CFA\\\\& =-\$248 + \$248\\\\&=\$0\end{aligned}$ | $\begin{aligned} &CA+CFA\\\\& =\small -\$248 + \$248\\\\&=\$0\end{aligned}$ | Balance of payments |