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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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For the sake of simplicity, let's assume that the current conversion rate is six Chinese yuan per for one US dollar. And at that exchange rate, China is exporting $50 million worth of goods to the United States and the US is exporting $20 million worth of goods to China. So clearly, there's a trade imbalance. The US is importing $50 million worth of goods and it's exporting $20 million worth of goods. So it has a $30 million trade deficit. Now, in this situation, the Chinese manufacturer is going to have $50 million that it wants to convert from its revenue in America and convert that to Chinese currency. The American manufacturer is going to want to convert its yuan into $20 million. So the supply of dollars, which is this $50 million right over here, is going to be much greater than the demand, which is a $20 million. So if the currencies were allowed to float, the dollar would weaken. The cost of the dollar would go down. Its supply is so much bigger than the demand. But let's say that the Chinese central bank does not want that to happen. So this is the Peoples Bank of China. They do not want the Chinese currency to strengthen because if that were to happen, then Chinese goods would become more expensive in the United States and it would be harder to maintain this trade imbalance. They want it. So what they do is they essentially make up for the difference in demand for the dollar. Right here there's only demand for $20 million. There's supply of 50. So what they do is they create demand for $30 million. And the way that they create demand for $30 million at that exchange rate is that they can literally print, create 180. They could literally create 180 million yuan. And then at an exchange rate of six to one, that would essentially-- and they would go out there into the open markets and try to convert this into dollars-- and so this would create a demand for an incremental $30 million. And so when they do that, the total demand for dollars is their $30 million plus the $20 million from the American manufacturer. That will completely equal the supply of dollars at that exchange rate. And so it will not cause the exchange rate to fluctuate or the balance of trade to change. So this is clearly a very simplified example. The actual numbers are much larger than in the millions. They're in the hundreds of billions of dollars. But this gives, at least in my mind, a respectable idea of how the Chinese central bank is actually keeping its currency pegged to the dollar and how that's helping to maintain a trade imbalance. This is Salman Khan of the Khan Academy for CNBC.