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Main content
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Video transcript

what I want to do in this video is to give you an intuitive sense of how a how a a and a market for currencies would actually work and it's it's very non-intuitive for a lot of people because we're going to be talking about currencies becoming more expense or more expensive or cheaper or the price of a currency in terms of another one and what I want to just give you a very intuitive feel for that so let's say well just you know because this is on it's a hot topic right now let's just make the two currencies the Chinese renminbi and the US dollar and the unit of exchange and China is a little confusing because sometimes I use the word renminbi sometimes the word one the one is the unit of the renminbi so let's say right now 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 ten ten one ten one per US dollar ten one is equal to one one US dollar and every time I say dollar in this video I'm referring to the US dollar is equal to one US dollar and I think this makes sense to a lot of people if I have one dollar I want to convert it to one I get ten of them if I have ten one 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 trading trade imbalances where this would actually happen but let's say we live in a reality where there are 1000 so let's say you know someone has a thousand won so let's say that this person right here let's say that this person right here has one thousand one right over here has has 1,000 won and wants to convert to dollars and wants to convert convert to dollars now let's say on this side and if we just superficially looked at this thousand won and look at the quoted rate we'd say hey that thousand won you divide you get ten won per dollar so that should be a hundred dollars at the quoted rate let's say you have two other actors over and obviously these markets involve many many more than just 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 let's say that this person right here with the moustache let's say this person right over there and maybe a hat as well let's say that he has let's say that he has let's say that he has $50 let me but let's say he has $100 has $100 as hundred dollars that that he needs to convert convert to one maybe he wants to buy some Chinese goods maybe he's a Chinese factory owner who sold his goods in the US for hundred dollars and now he needs to convert it back to one to pay his employees or pay his own mortgage or who knows what and let's say that there's another person let's say that there's another character over here there's another character over here and let's say that she also let's say that she also has let's say that she also has let's say that she has a hundred dollars that that need need to be converted converted into one so net-net what's happening here what's the total demand to convert one into dollars and dollars into one well if you look at the whole market you have 200 dollars that need to be converted into one let me write this down we have a situation where $200 $200 need to be converted into one and then to kind of off the on the other side of that transaction we have one thousand one need to be converted into dollars so now we have one thousand one one thousand one need to be converted in $2 and for simplicity these are the only actors these they are representing the entire market although as we know the entire you know in currency markets especially there's 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 one the the last exchange that occurred and said hey you know what me over here this hundred dollars I should be able to convert it into a thousand one but she also says I should be able to convert this hundred dollars into a thousand one so they collectively think that that two hundred dollars can be converted into two thousand one so I'll put this in question marks so will they be able to convert this into two thousand one into two thousand one and on this person over here you know he's saying well you know just at the current exchange rate maybe I'll be able to get maybe I'll be able to get for my thousand one maybe I'll get a hundred dollars 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 two thousand one remember what I said is this is the entire market it's a huge simplification but there is this imbalance here more dollars into one than one or two dollars now they won't be able to convert into two thousand one because there's only one thousand one that wants to be traded there is only one thousand one 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 his first he puts let's say he at first he puts ten one up essentially for bid you could view it either way you could say that maybe one of these people put a dollar up for bid and this guy is bidding on that dollar in terms of one or this guy's putting one 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 in more in demand so this since this guy is more in demand more more demand to simplify things I'll make him the person that's kind of able to create a an auction type situation which really what is what the markets are trying to do so that you can equalize supply and demand so he might put out he might he might initially say hey you know what I want to convert I want to he's gonna he has a hundred one and he's going he wants to convert it so he says you know what I'm willing to sell a hundred one for ten dollars so let's say he sells 100 one for ten dollars so he sells 100 or offers I should say offers offers to sell 100 101 for ten dollars he just thinks that that's a fair offer price right over there and that's this guy over here this guy actually converting one into dollars well what's going to happen well one of these people are just going to jump in that they say oh you know what I think that's a fair price and so let's say this woman right over here takes it then actually both of them maybe have saw that offer to sell 101 for ten dollars and they both try to click their mouse or however they're trying to make the transaction happening 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 let's call this person B and this is person a and this is person C so person B so person B accepts 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 one per US per US dollar and then this guy goes like my god I need to convert my money into one but I wasn't able to someone else beat me to the punch so this guy over here is not an idiot he's like hey maybe people are willing to give me more dollars per one so let's say that this guy right over here this guy in orange he then offers he then offers offers to sell to sell let's say he wants to sell 9191 for $10 notice the price of the wand has now gone gone up or the price of the dollar has now gone down either one those are 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 one so he accepts really fast so person a accepts I'm doing a huge oversimplification but gives you the general idea to show you that this really is a market so person person a accepts all of a sudden we have a new quoted exchange rate we all of a sudden we have an exchange rate of what is this nine ones so we have new new quoted rate or the transaction happens at nine wons nine ones per per dollar now what's happening and I think you see the dynamic that's going to happen there's more dollars that need to be converted into one then one that needs to be converted in dollars so this guy as he sees that there's a lot of demand to get his 1,001 he's going to keep offering fewer and fewer ones per dollar or these guys are going to keep are going to start accepting fewer and fewer wants for each of their dollars so as this happens as the price of the wand will go up notice the price of the wand went up here it was ten ones per dollar now is nine ones 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 it's actually it's actually dependent there's no mathematical formula 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 results here and this is the kind of what I really want you to get from this video is that because there's no there's no law in a 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 one than dollars as we see in this example the price of the dollar will go down so the price of dollar will go down I'll do this in a price of dollar will go down and then which is the exact same thing which is which me means the exact same thing as the price price of one will go up I really want you to internalize this we'll go up in terms of dollars price of dollars in terms of one will go down and this is 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 one over here the the demand for one is exceeding its supply so price will go up and or you could 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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