If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Currency effect on trade

Currency Effect on Trade. Created by Sal Khan.

Want to join the conversation?

  • blobby green style avatar for user Robert Freeburg
    If the Yaun is in greater supply than the dollar, why doesn't the dollar go up and the Yaun down. It seems backwards.
    (15 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Himanshu Bhandoh
      No. In the example cited in the lecture, the supply of Yuan is lesser than the dollar. The demand for Yuan is greater than the dollar. The Chinese doll manufacturer has in his hands $100.The Cola guy wants to convert his 500 Yuans to $50. Therefore in a way, the Chinese doll manufacturer has found somebody willing to take $50 in exchange for 500 Yuans. But there are still $50 left with the Chinese guy and he has nobody to exchange it with(Note:this example is simplistic,i'll get to what actually would happen). Therefore--> supply of dollars is high. Supply of Yuans is low.
      In a slightly more practical scenario, the fact that there is a greater supply of dollars and lesser supply of Yuan would change the exchange rate. The rate of 10 Yuan to $1 would have remained the same had the US Cola company guy possessed 1000 Yuans to convert to 100 dollars according to 10Y<->$1. Assuming that there is nobody else in the world willing to exchange yuans with dollars or vice versa, and the Cola guy and Doll guy are the only people left to exchange currency- $100 would need to be converted to 500 Yuan, making the exchange rate 5 Yuan to 1 Dollar.
      In a properly practical scenario without any assumptions, there would be more people willing to exchange currencies. But since the demand for yuan is higher because of the doll company exporting more than the cola company, the exchange rate would change very slightly. With a lesser number of yuans giving u 1 dollar(say 8 Y to $1 as in the lecture!)
      Yup, that's pretty much it! :)
      (45 votes)
  • blobby green style avatar for user James Fishtins
    Is this a constant dynamic between countries? Will there always be trade imbalances or can countries get to a point where it is consistently balanced?
    (9 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Kelsey Larson
      There aren't always huge imbalances, but there are always slight shifts in exchange rate. For example, let's start with two countries, A and B, that have a perfect trade balance. Then, 1 day, a study comes out in A saying that a fruit that only grows in B can cure cancer. Naturally, this would raise demand for B's fruit, creating a slight trade imbalance. This would then fade as rising demand for B's currency led trade to level out again at a different exchange rate. Millions of these slight adjustments happen every day in international markets, leading to fluctuations in exchange rates. Even if 2 nations are generally quite balanced, there will frequently be slight shifts in rates. So yes, it is a constant dynamic, but also yes, it can be quite consistently balanced with only marginal shifts.
      (12 votes)
  • blobby green style avatar for user Andrew Collins Hatkoff
    I am wondering. Where exactly are these conversion/transactions taking place. For instance when the US receives 500 Yuan, does this occur at a International Bank? The Federal Reserve? Furthermore when this happens where exactly does it do the conversion?
    (12 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Frederick.Phillip.Wolff
    Let's say that China is secretly printing more money because they know the value of their currency is going up in relation to the US's. Would this increase their purchasing power (let's say if they wanted to outbid a Texas company to build a highway in Texas or purchase American land) or would the market figure out this inconsistency and correct itself? If the market doesn't, I see no reason why a gov't wouldn't secretly print out money for foreign investments.
    (8 votes)
    Default Khan Academy avatar avatar for user
    • mr pants teal style avatar for user Wrath Of Academy
      If the Chinese print 1 trillion Yuan in secret and store it in a secret vault and never spend it, then it won't affect the exchange rate. But as soon as the money is in circulation, the "secret" is out. What matters is the amount in circulation that can affect the supply/demand for each currency.

      If the US starts exporting deeds to US land, the US land-sellers will now own tons of Yuan and look to offload it into dollars. So, the price of Yuan would fall, just as with any other trade imbalance.
      (2 votes)
  • blobby green style avatar for user Danielflackoccupy

    So does that mean in theory the supply and demand of the currency,is suppose to balance the supply and demand of the goods?
    (5 votes)
    Default Khan Academy avatar avatar for user
    • leaf red style avatar for user donnelly.rose
      These are two separate markets: currency and goods.

      Ideally the two markets would be both in equilibrium. If your market is limited to two countries mentioned, the two markets would balance at equilibrium price/quantity.

      The real world is not as simple.
      (4 votes)
  • piceratops tree style avatar for user Ojas Sahasrabudhe
    I have two questions. The first one is that if the price of the dollar goes down, as said in the video, it seems that the cola company would benefit from it! Is it so or it is only the common man who suffers or is it beneficial to the cola company??
    (3 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Georgette Frazer
      When the dollar goes down in value, U.S. consumers find that prices go up for the foreign goods they want to buy, and it's more expensive for them to travel outside the U.S.

      On the other hand, lower dollar values encourage exports of U.S.-made goods. That's good for business and employment here stateside. So whether or not lower dollar values are good or not depends upon your personal perspective.
      (3 votes)
  • leaf green style avatar for user Mohammed Ibrahim
    Is this the reason why certain products in foreign countries are available at cheaper rates comparatively to the same products available in a person's own country?
    for example iphone in US is 400 dollars but on conversion with exchange rate of a given country does not equal to the actual price of the iphone in that country which is double the currency exchange rate.Is this the reason why people pick up items from foreign countries rather than buying from their own country?
    (2 votes)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Andrew M
      There are many reasons for price differentials. Exchange rates are certainly one. Labor costs and taxes also have a large impact. Companies also may choose to set prices differently in different markets, depending on the companies' view of price sensitivity in each market. Over a long period of time, there is a tendency for currencies to move toward "purchasing power parity" (PPP), which means that easily tradable goods should be priced the same everywhere, but there are many forces that interfere with PPP, and conditions are always changing, so the world never settles into one PPP-induced set of exchange rates.
      (4 votes)
  • aqualine sapling style avatar for user Andrea
    If we buy/sell currency over the counter ... let's say in a small exchange desk in the airport ... will the transaction affect the exchange rate like it was done in the exchange market ?
    (1 vote)
    Default Khan Academy avatar avatar for user
    • orange juice squid orange style avatar for user Ctrader621
      Yes it will to some small extent affect the currency market because at some point the small exchange desk will have too much foreign currency and need to convert it to local currency so that they can continue to trade with travelers and stay in business. They will likely get a better exchange rate than what they were offering to you because they will be trading in greater volume and are able to carry their currency to a bank. Part of the premium you pay at the airport is for small volume and part is for the convenience.
      (5 votes)
  • blobby green style avatar for user Duncan Henry
    The US guy with the 500 Yuan says hey I will only give 8 yuan for 1 dollar instead of 10 because there is high demand. Right?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • leafers seed style avatar for user jaaranda90
      In the lecture there is a high demand for Yuan. I think of it the same way if I were selling any product. Instead of selling my 500 Yuans for 50 dollars, why not try to see if there is a willing buyer that will except 500 Yuans for 62.5 dollars (500 Yuan * 1 USD/8 Yuan).
      (1 vote)
  • piceratops ultimate style avatar for user Firedrake969
    So more demand for one = price of it goes up ?
    (3 votes)
    Default Khan Academy avatar avatar for user

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.