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## The foreign exchange market

# Currency exchange introduction

AP.MACRO:

MKT‑5 (EU)

, MKT‑5.A (LO)

, MKT‑5.A.1 (EK)

, MKT‑5.B (LO)

, MKT‑5.B.1 (EK)

, MKT‑5.B.2 (EK)

, MKT‑5.D (LO)

, MKT‑5.D.1 (EK)

## Video transcript

What I want to do in this
video is to give you an intuitive sense of how a market
for currencies would actually work. And it's very non-inuitive for
a lot of people because we're going to be talking about
currencies becoming more expensive or cheaper, or the
price of a currency in terms of another one. And what I want to do
is give you a very intuitive feel for that. So let's say, just because this
is a hot topic right now, let's just make the two
currencies the Chinese renminbi and the U.S. dollar. And the unit of exchange in
China is a little confusing because sometimes they use the
word renminbi and sometimes the word yuan. The yuan is the unit
of the renminbi. So let's say right now, if
I were to just go on some website-- and this is not the
actual exchange rate right now, but let's say right now the
quoted exchange rate is 10 yuan per U.S. dollar. 10 yuan is equal to $1. And every time I say dollar in
this video, I'm referring to the U.S. dollar. And I think this makes sense to
a lot of people, if I have $1, I want to convert it to
yuan, I get 10 of them. If I have 10 yuan, I want to
convert it to dollars, someone's going to give
me a dollar for it. Now let's imagine a situation,
and in the next few videos I'll construct actual trade
imbalances where this would actually happen, but let's say
we live in a reality where there are 1,000 yuan. So let's say someone has
1,000 yuan and wants to convert to dollars. Now, let's say on this side, and
if we just superficially looked at this 1,000 yuan and
looked at the quoted rate, we'd say, hey, that 1,000 yuan,
you get 10 yuan per dollar, so that should be
$100 at the quoted rate. Let's say you have two other
actors over here, and obviously these markets involve
many, many, more than just the three people, but this
will help us simplify, or at least understand how these
exchange rates would work. Let's say that this person right
here with the mustache and maybe a hat as well, let's
say that he has $100 that he needs to convert to yuan. Maybe he wants to buy some
Chinese goods, maybe he's a Chinese factory owner who sold
his goods in the U.S. for $100 and now he needs to convert
it back to yuan to pay his employees or pay his own
mortgage or who knows what. And let's say that there's
another person, and let's say that she also has $100
that needs to be converted into yuan. So net, what's happening here? What's the total demand to
convert yuan into dollars, and dollars into yuan? Well, if you look at the whole
market, you have $200 that needed to be converted
into yuan. Let me write this down. We have a situation where
$200 needs to be converted into yuan. And then, on the other side of
that transaction, we have 1,000 yuan that needs to be
converted into dollars. So now we have 1,000 yuan. And for simplicity, these
are the only actors. They are representing the entire
market, although, as we know, in currency markets
especially there's thousands or even millions of
actors actively participating in them. So what's going to happen? All of these people might just
go on the internet and look up the current exchange rate,
or the last exchange that occurred and say, hey this
$100, I should be able to convert it into $1,000 yuan. But she also says, I should be
able to convert this $100 into 1,000 yuan, so they collectively
think that that $200 can be converted
into 2,000 yuan. I'll put this in
question marks. So will they be able to convert
this into 2,000 yuan? And this person over here, you
know, he's saying just at the current exchange rate, maybe
I'll be able to get-- for my 1,000 yuan, maybe
I'll get $100. But everyone wants to maximize
the amount of the other currency they get for
obvious reasons. They want to maximize the amount
of money they get. Now, will these two people be
able to convert their money into 2,000 yuan? Remember what I said, this is
the entire market, and it's a huge simplification, but there
is this imbalance here. More dollars into yuan than
yuan into dollars. Now they won't be able to
convert into 2,000 yuan because there's only 1,000 yuan
that wants to be traded. So you can imagine, this guy
over here, maybe he wants to do it slowly just to kind of see
what the market is like. So let's say at first
he puts 10 yuan up, essentially for a bid. You could view it either way,
you could say that maybe one of these people put $1 up for
bid, and this guy's bidding on the dollar in terms of yuan, or
this guy's putting yuan up for bid and these guys are going
to bid on it in terms of dollars, either one. And that's why it's sometimes
confusing with currencies, because you're buying
another currency. But since this guy is more in
demand, to simplify things I'll make him the person that's
kind of able to create an auction-type situation. Which really is what the markets
are trying to do, so that you can equalize
supply and demand. So he might initially say he has
$100 yuan and he wants to convert it, so he says,
you know what? I'm willing to sell
100 yuan for $10. So let's say he sells
100 yuan for $10. so he sells 100-- or offers I
should say, offers to sell 100 yuan for $10, and he just thinks
that that's a fair offer price right over there. And that's this guy over here,
this guy actually converting yuan into dollars. Well, what's going to happen? Well one of these people is just
going to jump at that and say oh, you know what, I think
that's a fair price. And so let's say this woman
right over here takes it. Actually both of them maybe
saw that offer to sell 100 yuan for $10, and they both try
to click their mouse or however they're trying to make
the transaction happen. But let's say she clicks her
mouse a little faster and she gets the transaction. So let's say that person, let's
call this person B. And this is person A and
this is person C. So person B accepts. So two things happen just then:
One is, person C says, wow that was pretty fast,
someone was very willing to take it for 10 yuan per U.S.
dollar and this guy goes, my god, I need to convert my
money into yuan, but I wasn't able to. Someone else beat
me to the punch. So this guy over here is like
hey, maybe people are willing to give me more dollars
per yuan. So let's say that this guy right
over here-- this guy in orange-- he then offers to sell,
let's say he wants to sell 90 yuan for $10. Notice the price of the yuan has
now gone up, or the price of the dollar has now gone
down, either one. Those symmetric statements,
they mean the exact same thing. So all of a sudden, this person
has a lot of dollars he needs to convert into yuan, so
he accepts really fast, so person A accepts. I'm doing a huge
oversimplication, but it gives you the general idea
to show you that this really is a market. So person A accepts. All of a sudden, we have a
new quoted exchange rate. We all of a sudden have an
exchange rate of what is this, 9 yuan, so we have a new quoted
rate or the transaction happens at 9 yuan per dollar. Now what's happening? I think you see the dynamic
that's going to happen. There's more dollars that need
to be converted into yuan then yuan that needs to be converted
into dollars. So this guy actually sees
there's a lot of demand to get his 1,000 yuan. He's going to keep offering
fewer and fewer yuan per dollar. Or, these guys are going to
start accepting fewer and fewer yuan for each
of their dollars. So as this happens, as the price
of the yuan will go up. Notice, the price of the
yuan went up here. It was 10 yuan per dollar, now
it's 9 yuan per dollar. Or you could say the price of
the dollar has gone down. And this will just keep
happening until all of them are able to get rid
of their currency. There's no mathematical formula
to say what the clearing price is, it's actually
dependent on how badly each of these people are
willing to transact and really how good they are at
gaming each other. But the general result here,
and this is kind of what I really want you to get from this
video, is that because there's no law in a market
exchange rate mechanism that says this has to be the exchange
rate-- we'll explore how you can peg it in the
future-- but there's nothing that says that this has
to always be the case. If there's more demand for yuan
then dollars, as we see in this example, the price of
the dollar will go down. Which means the exact same thing
as the price of yuan will go up. I really want you to
internalize this. It will go up in terms of
dollars, price of dollars, in terms of yuan will go down. And this is the crux of
foreign exchange. If you can at least internalize
these ideas and to understand that there really is
this market out here based on the supply and
demand of yuan. Over here, the demand for yuan
is exceeding its supply. So price will go up. Or you can view it the other
way, the demand for dollars is below its supply, so the
price will go down. Anyway, I'll let you think about
that for a little bit. In the next video, we're going
to apply this concept to see how this freely floating
exchange rate can help equalize, or should help
equalize trade imbalances in an ideal world.