Currency Exchange Introduction

What I want to do in this
video is to give you an
intuitive sense of how a market
for currencies would
actually work.
And it’s very non-inuitive for
a lot of people because we’re
going to be talking about
currencies becoming more
expensive or cheaper, or the
price of a currency in terms
of another one.
And what I want to do
is give you a very
intuitive feel for that.
So let’s say, just because this
is a hot topic right now,
let’s just make the two
currencies the Chinese
renminbi and the U.S. dollar.
And the unit of exchange in
China is a little confusing
because sometimes they use the
word renminbi and sometimes
the word yuan.
The yuan is the unit
of the renminbi.
So let’s say right now, if
I were to just go on some
website– and this is not the
actual exchange rate right
now, but let’s say right now the
quoted exchange rate is 10
yuan per U.S. dollar.
10 yuan is equal to $1.
And every time I say dollar in
this video, I’m referring to
the U.S. dollar.

And I think this makes sense to
a lot of people, if I have
$1, I want to convert it to
yuan, I get 10 of them.
If I have 10 yuan, I want to
convert it to dollars,
someone’s going to give
me a dollar for it.
Now let’s imagine a situation,
and in the next few videos
I’ll construct actual trade
imbalances where this would
actually happen, but let’s say
we live in a reality where
there are 1,000 yuan.
So let’s say someone has
1,000 yuan and wants
to convert to dollars.

Now, let’s say on this side, and
if we just superficially
looked at this 1,000 yuan and
looked at the quoted rate,
we’d say, hey, that 1,000 yuan,
you get 10 yuan per
dollar, so that should be
$100 at the quoted rate.
Let’s say you have two other
actors over here, and
obviously these markets involve
many, many, more than
just the three people, but this
will help us simplify, or
at least understand how these
exchange rates would work.
Let’s say that this person right
here with the mustache
and maybe a hat as well, let’s
say that he has $100 that he
needs to convert to yuan.
Maybe he wants to buy some
Chinese goods, maybe he’s a
Chinese factory owner who sold
his goods in the U.S. for $100
and now he needs to convert
it back to yuan to pay his
employees or pay his own
mortgage or who knows what.
And let’s say that there’s
another person, and let’s say
that she also has $100
that needs to be
converted into yuan.
So net, what’s happening here?
What’s the total demand to
convert yuan into dollars, and
dollars into yuan?
Well, if you look at the whole
market, you have $200 that
needed to be converted
into yuan.
Let me write this down.
We have a situation where
$200 needs to be
converted into yuan.
And then, on the other side of
that transaction, we have
1,000 yuan that needs to be
converted into dollars.
So now we have 1,000 yuan.
And for simplicity, these
are the only actors.
They are representing the entire
market, although, as we
know, in currency markets
especially there’s thousands
or even millions of
actors actively
participating in them.
So what’s going to happen?
All of these people might just
go on the internet and look up
the current exchange rate,
or the last exchange that
occurred and say, hey this
$100, I should be able to
convert it into $1,000 yuan.
But she also says, I should be
able to convert this $100 into
1,000 yuan, so they collectively
think that that
$200 can be converted
into 2,000 yuan.
I’ll put this in
question marks.
So will they be able to convert
this into 2,000 yuan?
And this person over here, you
know, he’s saying just at the
current exchange rate, maybe
I’ll be able to get– for my
1,000 yuan, maybe
I’ll get $100.
But everyone wants to maximize
the amount of the other
currency they get for
obvious reasons.
They want to maximize the amount
of money they get.
Now, will these two people be
able to convert their money
into 2,000 yuan?
Remember what I said, this is
the entire market, and it’s a
huge simplification, but there
is this imbalance here.
More dollars into yuan than
yuan into dollars.
Now they won’t be able to
convert into 2,000 yuan
because there’s only 1,000 yuan
that wants to be traded.

So you can imagine, this guy
over here, maybe he wants to
do it slowly just to kind of see
what the market is like.
So let’s say at first
he puts 10 yuan up,
essentially for a bid.
You could view it either way,
you could say that maybe one
of these people put $1 up for
bid, and this guy’s bidding on
the dollar in terms of yuan, or
this guy’s putting yuan up
for bid and these guys are going
to bid on it in terms of
dollars, either one.
And that’s why it’s sometimes
confusing with currencies,
because you’re buying
another currency.
But since this guy is more in
demand, to simplify things
I’ll make him the person that’s
kind of able to create
an auction-type situation.
Which really is what the markets
are trying to do, so
that you can equalize
supply and demand.
So he might initially say he has
$100 yuan and he wants to
convert it, so he says,
you know what?
I’m willing to sell
100 yuan for $10.
So let’s say he sells
100 yuan for $10.
so he sells 100– or offers I
should say, offers to sell 100
yuan for $10, and he just thinks
that that’s a fair
offer price right over there.
And that’s this guy over here,
this guy actually converting
yuan into dollars.
Well, what’s going to happen?
Well one of these people is just
going to jump at that and
say oh, you know what, I think
that’s a fair price.
And so let’s say this woman
right over here takes it.
Actually both of them maybe
saw that offer to sell 100
yuan for $10, and they both try
to click their mouse or
however they’re trying to make
the transaction happen.
But let’s say she clicks her
mouse a little faster and she
gets the transaction.
So let’s say that person, let’s
call this person B.
And this is person A and
this is person C.
So person B accepts.

So two things happen just then:
One is, person C says,
wow that was pretty fast,
someone was very willing to
take it for 10 yuan per U.S.
dollar and this guy goes, my
god, I need to convert my
money into yuan, but
I wasn’t able to.
Someone else beat
me to the punch.
So this guy over here is like
hey, maybe people are willing
to give me more dollars
per yuan.
So let’s say that this guy right
over here– this guy in
orange– he then offers to sell,
let’s say he wants to
sell 90 yuan for $10.
Notice the price of the yuan has
now gone up, or the price
of the dollar has now gone
down, either one.
Those symmetric statements,
they mean
the exact same thing.
So all of a sudden, this person
has a lot of dollars he
needs to convert into yuan, so
he accepts really fast, so
person A accepts.
I’m doing a huge
oversimplication, but it gives
you the general idea
to show you that
this really is a market.
So person A accepts.
All of a sudden, we have a
new quoted exchange rate.
We all of a sudden have an
exchange rate of what is this,
9 yuan, so we have a new quoted
rate or the transaction
happens at 9 yuan per dollar.
Now what’s happening?
I think you see the dynamic
that’s going to happen.
There’s more dollars that need
to be converted into yuan then
yuan that needs to be converted
into dollars.
So this guy actually sees
there’s a lot of demand to get
his 1,000 yuan.
He’s going to keep offering
fewer and
fewer yuan per dollar.
Or, these guys are going to
start accepting fewer and
fewer yuan for each
of their dollars.
So as this happens, as the price
of the yuan will go up.
Notice, the price of the
yuan went up here.
It was 10 yuan per dollar, now
it’s 9 yuan per dollar.
Or you could say the price of
the dollar has gone down.
And this will just keep
happening until all of them
are able to get rid
of their currency.
There’s no mathematical formula
to say what the
clearing price is, it’s actually
dependent on how
badly each of these people are
willing to transact and really
how good they are at
gaming each other.
But the general result here,
and this is kind of what I
really want you to get from this
video, is that because
there’s no law in a market
exchange rate mechanism that
says this has to be the exchange
rate– we’ll explore
how you can peg it in the
future– but there’s nothing
that says that this has
to always be the case.
If there’s more demand for yuan
then dollars, as we see
in this example, the price of
the dollar will go down.

Which means the exact same thing
as the price of yuan
will go up.
I really want you to
internalize this.
It will go up in terms of
dollars, price of dollars, in
terms of yuan will go down.
And this is the crux of
foreign exchange.
If you can at least internalize
these ideas and to
understand that there really is
this market out here based
on the supply and
demand of yuan.
Over here, the demand for yuan
is exceeding its supply.
So price will go up.
Or you can view it the other
way, the demand for dollars is
below its supply, so the
price will go down.
Anyway, I’ll let you think about
that for a little bit.
In the next video, we’re going
to apply this concept to see
how this freely floating
exchange rate can help
equalize, or should help
equalize trade imbalances in
an ideal world.

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