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## Foreign exchange and trade

Current time:0:00Total duration:14:20

# Currency effect on trade

## Video transcript

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 in the
beginning of our time period, like we did in the last video,
that the exchange rate between the Chinese yuan and the
U.S. dollar is 10:1. So we have 10 yuan. So the last time people traded
these currencies, they exchanged 10 yuan for
1 U.S. dollar. And, when I say, dollar, I'm
going to implicitly mean the U.S. 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. 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
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, 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. 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 similar to this guy in
China, he needs to sell his product abroad for the
equivalent of $1, so that it can cover shipping costs,
manufacturing costs, and the high fructose corn syrup,
and all of that. 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 the current exchange
rate, let's say that there's a 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, which is equivalent to 10 yuan, then
there's going to be 100 people in some time period, let's say
it's a year or 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, demand for 50 cans in China. Obviously, these are
ridiculously low numbers. But we're just dealing
with simple numbers to help our thinking. Let me write the at current
exchange rate as well. So what we're saying is that, in
China, he needs to get $1. 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 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 like 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. Let me write this down. This is China. This is the U.S. over here. And what's the U.S.
going to do? Well, the U.S. is going to ship
over-- remember, he's selling this in the
United States. So each 10 yuan is $1. So for each doll, he's
going to get $1. So he's going to
get back $100. He is going to get back
$100 for his dolls. And then once he gets back $100
for his dolls, he's going to want to convert
them into yuan. So then he will try to convert
the $100 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. 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 his dollars, his
500 yuan into-- Now, what's the exchange rate that he
wants to, his goal is? To cover his costs, he
has to get 10:1. So 500 yuan into $50. 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 into 1,000 yuan. Let me write it here. 1,000. I should have written
it 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 U.S. 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 worth of goods to the U.S.
This guy is only shipping $50 worth of goods to China. So there's a net trade
imbalance of $50. China is shipping $50 more to
the U.S. 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, or 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. There's only 500 yuan
being sold. Or you could view it
the other way. There's only demand for $50. And there's $100 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, 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 yuans for each of the dollar. 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 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. 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. So let's think about how much
his dolls cost. So his dolls, in the U.S., now that the
yuan has appreciated, they were 10 yuan. And then, times-- we have
$1 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. 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. 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. 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 $1, there was a demand
for 100 dolls in the United States. But now that the price has gone
up to $1.25, 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, 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 U.S. perspective, and shipping fewer 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, are 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. And, eventually, you
should have some type of trade balance.