What I want to do in this video is explore how the floating exchange rate could, in theory, help resolve trading imbalances. And for this simplified example, We are going to assume that the exchange rate between the Chinese Yuan and the US $ is 6 Yuan per 1 US $. And also for simplification, we are going to assume that China is only exporting one thing to the United States and that one thing is microwaves. And at 6 yuan per $, the Chinese manufacturer is going to sell them in the United States for $50 each. And at that price, there is a demand in the US for 1 million microwaves. I'm also going to assume that the only export from the US to China is software. And they have demand for 2 million units if they sell them at 60 yuan per unit. So let's think about what the demand for the each of the currencies will be from each of the manufacturers. So the Chinese manufacturer over a year is going to sell a million units for $50 each. So he's gonna get $50 million dollars in revenue And he is going to want to convert that $50 million into yuan. So you can kind of view this as a supply. This right over here is the supply of US dollars. And we are going to assume that these are the only people that are creating currencies, because they are the only people trading in this ultra simplified world. Now the US manufacturer is going to sell 2 million units at 60 yuan each. So that's going to be 120 million yuan of revenue. And he is going to want to convert this into dollars at the prevailing exchange rate right then which is 6 yuan per dollar. So he's going to want to convert this. He divides this by 6. He's going to want to convert that into 20 million dollars. And obviously, he's going to want to convert into yuan, because that's where his costs are in, that's where he lives. This guy wants to convert into dollars, because that's where his costs are. Now this is the supply of dollars. These dollars wants to be converted into Chinese currency. This right here is the demand for dollars. This is the amount of $ needed by a guy converting from yuan. Now clearly, there is an imbalance. The supply of $ is much larger than the demand for $ in this situation. And anytime the supply for anything is larger than the demand... If the supply is larger than the demand then that means the price must go down. And we talk about the price of a currency, in this case, the price of the dollar going down. We are talking about in terms of yuan. So the dollar... ...the dollar will go down. The price goes down which means the yuan goes up. The dollar will become weaker. The yuan will become stronger. Now, if that happens, what happens to the prices over here? If the yuan becomes stronger, we start seeing 4 yuan or 5 yuan per $ or even 3 yuan per $. Then this Chinese manufacturer won't be able to afford to sell at only $50. He is going to have to raise the price in order to cover his costs in Chinese currency. 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 yuan. Now he needs fewer yuan 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 yuan would become stronger, if you had a floating exchange rate, the demand for Chinese goods would go down and the demand for the US goods would go up. And eventually, you would have this trade and currency imbalance resolve itself. Now, this is all theoretical, and reality is that it's not allowed to float. We'll describe that more in future videos. This is Salman Khan from the Khan Academy for CNBC.