Currency Effect on Trade Currency Effect on Trade
Currency Effect on Trade
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- What I want to do in this video is explore how trade imbalances, in theory, should be resolved by freely floating currencies.
- So let's just say, that at the beginning of our time period — like we did in the last video
- that the exchange rate between the Chinese Yuan and the US dollar is 10 to 1.
- So the last time people traded these currencies, they exchanged 10 Yuan for 1 US dollar.
- And, when I say "dollar," I'm going to implicitly mean the US dollar.
- Now, let's think about two entrepreneurs in each of the countries — or one in each of the countries.
- So let's talk about a Chinese entrepreneur.
- So we are in China here, and he makes dolls.
- He makes dolls. So let me draw one of the dolls.
- And in order to profitably sell a doll, he needs to sell them for 10 Yuan.
- If he's able to sell for the equivalent of 10 Yuan in the United States
- and we won't talk a lot about shipping and what currency you'd have to pay it in, and all of that
- then he can pay all of his needs — maybe even the shippers across the Pacific
- maybe their employees are also Chinese, so they want their money in Yuan.
- And obviously, most of the cost would be for manufacturing this doll.
- And all of his employees want to be paid in Yuan.
- His own rent for the factory, or even his own rent for his own house, it all has to be paid in Yuan.
- So this is what he needs to sell his doll for:10 Yuan.
- And at the current exchange rate, that would be 1 US dollar.
- Now, let's go across the Pacific.
- Let's go to the United States.
- And let's say that we have another entrepreneur who is making soda, or making cola, for export.
- So let me draw a can of cola.
- And similarly to this guy in China, he needs to sell his product abroad for the equivalent of a dollar,
- so that he can cover shipping costs, and the manufacturing costs, and the high fructose corn syrup, and all of that.
- So needs to sell for 1 US dollar.
- And once again, he cares about dollars, because he has to pay his own mortgage in dollars
- his employees need to be paid in dollars — maybe the shippers he used, they only accept dollars.
- So this is how both of these characters think about it.
- Now at this current exchange rate, let's say that the demand for these dolls
- that there is demand for 100 dolls in the United States.
- This guy is exporting, and so is this guy.
- We'll make it very simple.
- They're only focused on exports.
- So at current exchange, (and I'll do it for both), for the doll guy, there is demand for 100 dolls in the United States.
- So what does that mean?
- That means that if he can sell these dolls for 1 dollar — which is equivalent to 10 Yuan
- then there are going to be 100 people in some time period — let's say it's a year or a month
- who are going to be willing to buy the dolls at that price.
- And let's say — also at this current exchange rate — in China, 50 people are willing to buy this cola.
- So at the current exchange rate, there is demand for 50 cans of cola in China.
- (Obviously, these are ridiculously low numbers, but we're just dealing with simple numbers to help our thinking.)
- And let me write the phrase "at current exchange rate" as well.
- So what we're saying is that, in China, he needs to get a dollar.
- At the exchange rate, that's 10 Yuan.
- So if he were to — at a store in China, or to a distributor in China, maybe
- sell each of these cans for 10 Yuan, there's demand for 50 cans of cola in China.
- Now, what's going to happen here?
- I think some of you all might already see that a trade imbalance is developing.
- So what's going to happen here?
- So this guy, he likes doing this — and this guy likes doing it — so what's going to happen?
- In this time period, this Chinese guy is going to ship over 100 dolls to the United States.
- So let me write this down. This is China. This is the US over here.
- And what's the US going to do?
- Well, the US is going to ship over — essentially
- Remember, he's selling this in the United States.
- So each 10 Yuan is 1 dollar.
- So for each doll, he's going to get 1 dollar.
- So he's going to get back 100 dollars for his dolls.
- And then, once he gets back 100 dollars for his dolls, he's going to want to convert them into Yuan.
- So then he will try to convert the 100 dollars into yuan.
- So this is what'll end up happening for this guy.
- And let's say these are the only two people trading between China and the United States, just to really simplify things.
- Now let's think about what happens on the right side over here.
- This guy is going to ship 50 cola cans to China.
- So we have a cola can right over there — cola.
- He is going to ship 50 of them to China from the United States.
- And what is he going to get back in return?
- Well, it's being sold to Chinese distributors, so they're going to pay him in Yuan.
- So for each can, at the current exchange rate — or at the current price — he's going to get 10 Yuan.
- So when you convert it back, he's going to get 10 Yuan per can.
- So 10 Yuan times 50 is 500 Yuan.
- 500 Yuan is what he's going to get.
- And then, he's going to try to convert
- Let me write that in a different color, just really for the sake of it.
- So he's going to try to convert — because he has to pay his expenses in dollars — his 500 Yuan into
- Now, what's the exchange rate that he wants to get — his goal?
- To cover his costs, he has to get 10 to 1.
- So 500 Yuan into 50 dollars.
- And let me make it clear: this guy thinks he's going to get 10 Yuan for every dollar
- so he wants to convert his 100 dollars into 1,000 Yuan.
- So let me write it here: 1,000 Yuan.
- I should have written it over here. 1000 yuan over here.
- So what just set up?
- If these are the only people trading goods and currency in this time period, what did we just set up?
- Well, clearly, this guy is shipping more value to the US than this guy is shipping to China.
- There's a trade imbalance.
- If you think of it in terms of dollars, this guy is shipping 100 dollars worth of goods to the US,
- while this guy is only shipping 50 dollars worth of goods to China.
- So there's a net trade imbalance of 50 dollars.
- China is shipping 50 dollars more to the US then the other way around.
- If you think about it in Yuan, it would be a trade imbalance of 500 Yuan.
- And because of that, this guy is trying to convert many more dollars into Yuan than this guy is trying to convert the other way around.
- Notice: there is more demand for Yuan than dollars.
- What's going to happen — especially if these are the only two people trading?
- If these are the only two people trading, this guy is going to say, "Hey, I've got 10 Yuan."
- "Let me convert it into dollars."
- It'll be just like what we saw in the last video.
- And, obviously, there'll be more actors here.
- But this guy has more stuff to convert than this guy.
- In fact, if these were the only two people trading,
- he wouldn't even be able to convert all of his currency into Yuan,
- because there's only 500 Yuan available on the market.
- This guy thinks he should get 1,000 Yuan.
- And, obviously, if the price of the Yuan goes up, like we've seen in the previous video,
- maybe there will be more people who want to convert Yuan, maybe fewer people who'd want to convert dollars.
- So we can think about all of those.
- But I really want to think about how this will potentially resolve the trade imbalance.
- So we have a situation with more demand for Yuan than dollars.
- There's a demand for 1,000 Yuan here, but there's only 500 Yuan being sold.
- Or you could view it the other way.
- There's only demand for 50 dollars.
- And there's 100 dollars being sold.
- Either way there's an imbalance.
- So what's going to happen?
- Well, you're going to have either — depending on how you want to view it
- you could say that the price of the dollar will go down.
- Or you could say that the price of the Yuan will go up.
- And the dynamics would be like we saw in the last video.
- This guy over here would sell a couple of his Yuan.
- And he'd say, "Wow, there's this guy over there who really wants to buy it."
- And then maybe he'll keep saying, "Well, you know what, instead of giving me a dollar for every 10 of my Yuan,
- why don't you give me a dollar for every 9 of my Yuan?"
- Or eventually, "Why don't you give me a dollar for every 8 of my Yuan?"
- And so he'll keep raising the price of the Yuan.
- He'll keep giving fewer and fewer Yuan for each of the dollars.
- Let's say this goes on for a little bit.
- And I really want to explore the trade imbalance.
- Let's say at some point — and, obviously, maybe more and more people come into the market.
- So, eventually, it clears.
- Because, right now, there isn't enough Yuan for this guy.
- But as you can see, the price of the Yuan goes up.
- So after all of this, because of this trade imbalance,
- because more people want to convert dollars into Yuan than Yuan into dollars, the currency changes.
- So you could imagine — and I'm just going to make up some numbers here — that the Yuan becomes more expensive.
- It was 10 Yuan to the dollar; now maybe it is 8 Yuan to the dollar.
- So this is where we get to eventually.
- Because of this supply demand imbalance right over here.
- 8 Yuan to a dollar.
- Now, what's the reality over here?
- This guy over here needs to sell his dolls for 10 Yuan, which before was the equivalent of 1 dollar.
- But now, how much is he going to sell his Yuan for?
- He needs to sell for 10 Yuan.
- That's 8 Yuan per dollar. Right?
- So let's think about how much his dolls cost.
- So his dolls, in the US, now that the Yuan has appreciated, they were 10 Yuan.
- And then, times — we have 1 dollar for every 8 Yuan.
- So this is going to be equal to — (The Yuans cancel out.)
- This is really just dimensional analysis you might have learned in chemistry.
- So 10 over 8 is what?
- That's 1 and 1/4.
- This is $1.25. One dollar and 25 cents.
- Notice the price of his dolls went up in the United States in terms of dollars.
- And let's think about what happened to the cola manufacturer right over here.
- So his costs — or the price he needs to sell them for — are 1 dollar.
- And now what's the exchange rate?
- Let me write it the other way, because I need to cancel out the dollars.
- We have 8 Yuan for every 1 dollar.
- Dollars cancel out. 8 times 1.
- His selling price in China will now be 8 Yuan.
- So notice, neither of these people changed their prices in terms of their home currency.
- No change in price at all.
- But because of the currency movements, because the Yuan became more expensive,
- the Chinese manufacturer's goods are now more expensive in dollars.
- And the American manufacturer's goods are now less expensive in Yuan.
- So what's going to happen?
- What's going to happen here?
- At a dollar, there was a demand for 100 dolls in the United States.
- But now that the price has gone up to $1.25.
- now there will only be demand at this higher price for 50 dolls in the United States.
- And let's say this guy over here, before, there was demand for 50 cans of his cola in China
- because it was 10 Yuan — but now, the price has gone down.
- So now, you can imagine that there is demand — or actually I should say there's demand for 50 dolls.
- And, now, because this guy's price has gone down, now, instead of demand for 50 cans, maybe there's demand for
- and I'll just make up a number — 80 cans.
- Maybe there's now demand for 80 cans.
- So what just happened to the trade imbalance?
- Before, in terms of either currency, we were buying more dolls — if you think about from the US perspective — and shipping fewer cans of cola.
- But now, we're buying fewer dolls, because it's now more expensive in the United States. and we're shipping more cola.
- So I don't even know how this math works; I'm going to let you figure that out.
- But as one currency gets more and more expensive, those exports
- the demand for those exports from those countries is going to go down, like we saw with these dolls.
- And on the other side, as the other currency gets cheaper and cheaper and cheaper,
- the demand for those exports will go up; because in other currencies, it will look cheaper.
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