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Current time:0:00Total duration:4:06

Video transcript

what I want to do in this video is explore how a floating exchange rate could in theory help resolve trade imbalances and for this simplified example we're going to assume that the exchange rate between the Chinese when and the US dollar is six when per one u.s. dollar and also for simplification we're going to assume that China is only exporting one thing to the United States and that one thing is microwaves and at six UN per dollar the Chinese manufacturer is going to sell them in the United States for $50 each and at that price there's demand in the United States for 1 million microwaves I'm also going to assume that the only export from the u.s. to China is software and they have demand for 2 million units if they sell them at 60 when per unit so let's think about what the demand for each of the currencies will be from each of the manufacturers so the Chinese manufacturer over here is going to sell a million units at fifty dollars each so he's going to get 50 million dollars in revenue and he is going to want to convert that 50 million dollars into into yuan so you can kind of view this as the supply this right over here is the supply of US Dollars and we're going to see that these are the only people that are trading currencies because these are only people trading in this ultra simplified world now the u.s. manufacturer is going to sell two million units at sixty one each so that's going to be 120 million 120 million yuan of revenue and he's going to want to convert this into dollars at the prevailing exchange rate right then which is six one per dollar so he is going to want to convert this you divide this in by six he's going to wanted to convert that into twenty million dollars and obviously he wants to convert into when because that's what his costs are and that's where he lives this guy wants to convert in two dollars because that's where his costs are now this is a supply of dollars these dollars want to be converted into Chinese currency this right here is the demand for dollars this is the amount of dollars needed a guy converting from one now clearly there's an imbalance the supply of dollars is much larger than the demand for dollars in this situation and anytime the supply for anything is larger than the demand if the supply if the supply is larger than demand then that means that the price the price must go down when we talk about the price of a currency in this case the price of the dollar going down we're talking about in terms of U n so the dollar the dollar will go down the price goes down which means the when goes up the dollar will become weaker the when will become stronger now if that happens what happens to the prices over here if the yet we when becomes stronger and we start seeing for what v wind per dollar or for one per dollar even three wins per dollar then this Chinese manufacturer won't be able to afford to sell it at only $50 he is going to have to raise the price in order to cover his cost in Chinese currencies if he raises the price he's going to lower the demand on the other side of the equation the American manufacturer in order to get the same number of dollars he actually can sell it for fewer one now he needs fewer one per each dollar so he can actually lower the price in China and if he lowers the price in China that's going to increase the demand so what you have happening is because the wand would become stronger if you had a floating exchange rate the demand for Chinese Goods would go down and the demand for US goods would go up and eventually you would have this in this trade and currency imbalance resolve itself now this is all theoretical and the reality is that it's not that it's not allowed to float and we'll describe that more in future videos this is Salman Khan from the Khan Academy for CNBC