Main content

## Macroeconomics

### Unit 6: Lesson 3

The foreign exchange market- Currency exchange introduction
- Supply and demand curves in foreign exchange
- Accumulating foreign currency reserves
- Using reserves to stabilize currency
- Speculative attack on a currency
- Financial crisis in Thailand caused by speculative attack
- Math mechanics of Thai banking crisis
- Lesson summary: the foreign exchange market
- The foreign exchange market

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# Supply and demand curves in foreign exchange

AP.MACRO:

MKT‑5 (EU)

, MKT‑5.B (LO)

, MKT‑5.B.1 (EK)

, MKT‑5.B.2 (EK)

, MKT‑5.C (LO)

, MKT‑5.C.1 (EK)

In this video, learn about how the model of the foreign exchange market is used to represent the determination of exchange rates.

## Video transcript

- [Instructor] In a previous video, we've given an intuition on what foreign exchange
markets are all about. In particular, we talked about
the foreign exchange market between the U.S. dollar
and the Chinese yuan. What we're going to do
in this video is think about the same idea, but think
about it in terms of graphs and the types of economic
models that we're used to seeing in an introductory macroeconomics course. So what we're going to
focus on in this video is the foreign exchange market. Foreign exchange market for the Chinese yuan. Now, we're going to think about it in terms of supply and demand curves. It can be a little bit confusing because we're gonna be thinking
of the price of the yuan in terms of another currency,
in this case the dollar, although you could do it in
terms of other currencies, the pound or the euro or whatever else. Now, this can be a little bit confusing because we're going to be thinking about currency on both axes. But let's first think
about the horizontal axis that when we're thinking
about most markets, that is our quantity axis. And here once we're going
to think about quantity. We're gonna think about the quantity. Quantity of Chinese yuan. And then our vertical axis, we're essentially going to
be thinking about the price of the Chinese yuan. But how do you think about
the price of a currency? Well, we're going to think of it in terms of another currency. And for the sake of this video, that other currency is
going to be the U.S. dollar. So this is going to be U.S. dollars per Chinese yuan. And I encourage you, pause this video. Think deeply about why it's
U.S. dollars per Chinese yuan, as opposed to Chinese
yuan per U.S. dollars. And think about why I put the
quantity of Chinese yuan here instead of the quantity of U.S. dollars, because this is the
foreign exchange market for the Chinese yuan. I could have done another chart where it's the foreign exchange
market for the U.S. dollar, in which case then my
quantity would be U.S. dollar. And then I would think of how much of some other currency per U.S. dollar. So I would say maybe how much
Chinese yuan per U.S. dollar? But here it's the other way around. I'm in the market for the Chinese yuan. So let's think about the
supply and demand curves and which way they would work. Well, imagine that people are
offering very few U.S. dollars per Chinese yuan. Well, in that world, a lot of
people might not wanna convert their yuan into dollars. They might not offer them up for supply to be converted into U.S. dollars. The quantity of Chinese yuan, if the price for the Chinese yuan is low, might be pretty low. And as the price people are willing to pay in terms of dollars goes up, well, more and more people
might be willing to transact. So our supply curve, and here
we're talking about the supply for Chinese yuan, is likely to increase as people are willing to
pay more for those yuans. And this is like many markets
that we've seen before. It's just a little bit less intuitive because we're thinking about
markets for one currency in terms of another currency. Now, what about the demand curve? Well, the demand curve is gonna look like a lot of demand curves we've seen. If the price of a Chinese yuan is high, well, very few people
are going to demand it. And as the price of the Chinese yuan in terms of dollars is lower and lower, more and more people might
demand more Chinese yuan, go like, "Hey, it's cheaper
now in terms of U.S. dollars." So this is what a demand
curve might look like. And as you can imagine, this point is our equilibrium point, and it would tell us our
equilibrium exchange rate. We could call that our
equilibrium exchange rate, and this would be our
equilibrium quantity. So, for example, let's say
that our equilibrium quantity, and let's say this is the
quantity that changes hands in some time period, so let's say per day. Let's say or equilibrium
quantity is equal to 1,000 yuan. 1,000 yuan. And let me just call this Q sub one, is 1,000 yuan. These numbers are very low. Real exchange markets, we
might be talking about billions or tens or hundreds of billions or even sometimes trillions
of various currency. But let's just say for
argument it's 1,000 yuan is our current equilibrium
exchange quantity per day. And let's say this
exchange rate, e sub one, is equal to 10 cents per yuan. So 10 cents, or 1/10 of a U.S. dollar per Chinese yuan. So that's our current exchange rate. Now, let's say for some reason, all of a sudden Americans
become increasingly interested in converting their currency. Maybe they want to invest in China. Maybe all of a sudden the Chinese say, "Hey, Americans, come
buy property in China." A lot of people are interested. Well, what would happen here? Well, then the demand
for yuan would increase because you could only buy that
property in China with yuan, not with U.S. dollars. What would happen here? Well, your demand curve
would shift to the right like we've seen before. If we call this D one, then we could get to a new demand curve that might look something
like this, D two. Now, what would happen if our equilibrium exchange
rate doesn't change? Well, if this is our exchange rate, if this were to stay our exchange rate, now all of a sudden a higher
quantity is being demanded than is being supplied. The Americans in this situation, or it actually doesn't
even have to be Americans. It could just be whoever's
holding U.S. dollars, there's demand for more
than 1,000 yuan per day. Maybe this is 1,500 yuan
or whatever it might be. What you would naturally see
is that price of the yuan in terms of U.S. dollars will go up until you get to an equilibrium point. And on the first video when
we talk about the intuition of foreign exchange markets, we talk about why this would be. So you would then get
to a new equilibrium, right over here, this is e sub two, and a new equilibrium quantity. Let's call this Q two. Our new equilibrium quantity, Q two, might be 1,200 yuan per day
versus 1,000 yuan per day. And our new equilibrium exchange rate, maybe this is now equal
to 15 cents per yuan instead of 10 cents per yuan. So big picture, you can think
of the foreign exchange market in a lot of ways like we've looked at other markets in macroeconomics. It takes a little bit of an intuitive leap to just think about the
market for one currency in terms of another.