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Why must a CAD equal a KAFA surplus? (1 Viewer)

Kangaaroo

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For example, say an economy's CAD increases because of a worsening in the BOGS. From what I know, this must be balanced out by an increase in the KAFA surplus. But I don't understand how this happens - why would a deteriorating in the BOGS automatically lead to increased financial inflows?
 

quickoats

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There is a link between the elements of the KAFA and CA that logically flow (e.g. if there is high investment in Australia, KAFA positive, which means NPY would be negative - outflow of money from Aus to pay foreign investment). Usually, schools will teach this link (since it’s higher level thinking about relationships, cause and effect), but the reason why the BoP balances is much simpler.

The BoP balances since Australia uses a double entry accounting framework - a transaction can be recorded from 2 perspectives. Consider this (awful) example. A company in China wants to invest in an Australian mining company and pay for a 30% equity share, paid with 100 bananas. This comes under the definition of ‘direct investment’ (over 10%),into Australia. This transaction is recorded as a credit of 100 bananas on the DI section of the KAFA. But due to the transaction, Australia has 100 extra bananas delivered straight from China. We record this as an import, which is a debit of 100 bananas on our BOGS in the CA.

See how the BoP balances itself because when we made a positive entry on the KAFA, we also made an identical negative entry on the BOGS in the CA. The reason it balances is that for every transaction between Australia and the rest of the world, there are 2 perspectives to look at it through.

Note that the BoP doesn’t exactly balance - we have net errors and omissions which make the calculations slightly off. Things like tourist expenditure are hard to sum up and count on the BOGS, and things like military expenditure that are confidential may not make it to the BoP, which means that we’ll end up with a +/- balance which is negligible - just a technicality.

Have a look at this website, it might help. The examples may be a bit more complex, but surely more economically relevant than the bananas one. https://www.rba.gov.au/education/resources/explainers/the-balance-of-payments.html

if you need any clarification, feel free to ask :)
 

Kangaaroo

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There is a link between the elements of the KAFA and CA that logically flow (e.g. if there is high investment in Australia, KAFA positive, which means NPY would be negative - outflow of money from Aus to pay foreign investment). Usually, schools will teach this link (since it’s higher level thinking about relationships, cause and effect), but the reason why the BoP balances is much simpler.

The BoP balances since Australia uses a double entry accounting framework - a transaction can be recorded from 2 perspectives. Consider this (awful) example. A company in China wants to invest in an Australian mining company and pay for a 30% equity share, paid with 100 bananas. This comes under the definition of ‘direct investment’ (over 10%),into Australia. This transaction is recorded as a credit of 100 bananas on the DI section of the KAFA. But due to the transaction, Australia has 100 extra bananas delivered straight from China. We record this as an import, which is a debit of 100 bananas on our BOGS in the CA.

See how the BoP balances itself because when we made a positive entry on the KAFA, we also made an identical negative entry on the BOGS in the CA. The reason it balances is that for every transaction between Australia and the rest of the world, there are 2 perspectives to look at it through.

Note that the BoP doesn’t exactly balance - we have net errors and omissions which make the calculations slightly off. Things like tourist expenditure are hard to sum up and count on the BOGS, and things like military expenditure that are confidential may not make it to the BoP, which means that we’ll end up with a +/- balance which is negligible - just a technicality.

Have a look at this website, it might help. The examples may be a bit more complex, but surely more economically relevant than the bananas one. https://www.rba.gov.au/education/resources/explainers/the-balance-of-payments.html

if you need any clarification, feel free to ask :)
In the context of the HSC though, how would I articulate this? The example you gave makes sense but seems like it's outside the scope of the syllabus.
 

Zacharia Villegas

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Maybe a more simple way to look at it is that a CAD means money is being paid out of the eco into the global eco. So in order to balance that K leaving the country(from BOGS or NY), there must be an inflow of I theoretically and thus, including net omissions and errors CAD + KAFA = 0.
 

Kangaaroo

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Maybe a more simple way to look at it is that a CAD means money is being paid out of the eco into the global eco. So in order to balance that K leaving the country(from BOGS or NY), there must be an inflow of I theoretically and thus, including net omissions and errors CAD + KAFA = 0.
See I get this basic concept, but it doesn't make sense to me when I think about it. If the CAD increases because there's a larger outflow of debt servicing, for example, why does that automatically result in a proportional increase in foreign investment. I'm struggling to see the cause and effect.
 

quickoats

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Maybe a more simple way to look at it is that a CAD means money is being paid out of the eco into the global eco. So in order to balance that K leaving the country(from BOGS or NY), there must be an inflow of I theoretically and thus, including net omissions and errors CAD + KAFA = 0.
Capital leaving the country is actually contributing to a positive BOGS - export>import means that BOGS is positive - usually this is a CAS. This is how the categories link together and are mechanically related, but not the cause of the balance. The only reason why BoP zeroes out is that they use the double entry accounting method. EVERY singular transaction involving Australia and the rest of the world is recorded as 2 transactions.
I think you're on the right track of thinking, but its more like capital exported out of the country is EQUIVALENT to income coming into the country.

In your example, the capital leaving the country (an export) (positive BOGS) is immediately recorded on the KAFA as a debit in the 'other investment - trade credit'. We have provided something to the rest of the world and in return, the rest of the world pays us (we receive economic value in exchange for providing it).

In the context of the HSC though, how would I articulate this? The example you gave makes sense but seems like it's outside the scope of the syllabus.
This is quite a specific question for them to ask - "Why" does it equal zero? The answer is the double entry framework - but since this is a 'lower level' type of thinking (just regurgitating), they would more likely as a question about how certain categories are linked (like the NPY and FDI relationship I outlined). That question would be higher order thinking, and you'd answer it by explaining how they link e.g. high FDI in Australian means that KAFA ^, but that means we have a negative NPY as that is used to pay interest/earnings from the FDI back to its original country
 

Kangaaroo

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This is quite a specific question for them to ask - "Why" does it equal zero? The answer is the double entry framework - but since this is a 'lower level' type of thinking (just regurgitating), they would more likely as a question about how certain categories are linked (like the NPY and FDI relationship I outlined). That question would be higher order thinking, and you'd answer it by explaining how they link e.g. high FDI in Australian means that KAFA ^, but that means we have a negative NPY as that is used to pay interest/earnings from the FDI back to its original country
Right, but wouldn't the increase in NPY outflows be much less than the corresponding increase in FDI inflows? Like, if a company borrows 1 million dollars from overseas and pays a 5% interest rate per annum on that loan, then the inflow on the KAFA is 1 million but the outflow(s) on the NPY are only 50 thousand... so they're not equivalent.
 

quickoats

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Right, but wouldn't the increase in NPY outflows be much less than the corresponding increase in FDI inflows? Like, if a company borrows 1 million dollars from overseas and pays a 5% interest rate per annum on that loan, then the inflow on the KAFA is 1 million but the outflow(s) on the NPY are only 50 thousand... so they're not equivalent.
Yes, they're not equivalent, but they're linked. This is the 'higher order' thinking that NESA would want you to show when you answer "Explain the links and relationships between FDI and NPY". NESA are more likely to give questions like this (maybe even with a stimulus), as you actually have to think.

This question is not the same as "explain why the BoP balances", which is a 'lower order' thinking - all you'd have to say is "double entry accounting framework" and maybe chuck in something like economic value received on one end is equivalent to economic value provided.
 
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Maybe a more simple way to look at it is that a CAD means money is being paid out of the eco into the global eco. So in order to balance that K leaving the country(from BOGS or NY), there must be an inflow of I theoretically and thus, including net omissions and errors CAD + KAFA = 0.
you seem to be right
 

ultra908

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A derivation can come from the floating exchange rate.
Supply of $A = Demand for $A
Imports + Income outflow + Capital and Financial Outflow = Exports + Income inflow + Capital & Financial Inflow
M - X + Income (outflow - inflow) = Capital and financial (inflow - outflow)

The LHS is the deficit on the current account, and the RHS is the surplus on the capital and financial account. These should be equal, so when one changes, the other changes accordingly.
 

Velocifire

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NGL I don't do economics but this thread sounds pretty interesting to me.
 

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