The foreign exchange market
Using reserves to stabilize currency
Narrator: In the last video we saw how everyone in country A got excited about investing in country B and so they wanted to convert their currency into country B's currency. Left to its own devices with this new demand for currency B, it would have made currency B more expensive, but instead of allowing that to happen the central bank of country B said no, no, no, no, no, I want to keep the exchange rates relatively stable, so I'm going to print B's and use those to buy up A's. So at the end of that video the central bank of country B ended up with foreign currency reserves. It ended up with some of A's currency on its balance sheet. What I want to do in this video is think about what if demand goes the other way and how could the central bank use its foreign currency reserves to prevent its currency from devaluing. Let's go to the next stage in our little hypothetical story here. Let's say people in A, all of this investment happened in country B, everyone was all excited. Probably a bubble was forming of some kind and then all of the sudden the investors in country A start to get a little bit scared. They start to hear reports of the bubble forming, they start to realize that conditions in country B weren't as good as they thought it might have been initially, so they start to panic. They start wanting to unwind their investments. Whatever they had in country B they want to sell it, they get B's currency for it and they want to convert that to their home currency. Now you have the reverse situation of what we saw in the last video. Everyone wants to sell their B's, so they had invested in country B maybe they had bought some real estate there, they're going to sell their real estate, they're going to get B's for it and then they're going to get out of that countries currency. They're going to want to convert that money back in to A's, but this is the opposite situation. Now everyone wants to run out of country B and there isn't a lot of supply of A's in return. No one's really looking to trade A's for B's now. Everyone is irked, the market is going completely in the opposite direction. If, once again, foreign exchange markets were allowed to float freely what would happen? In this situation all the demand is for the A's and all the supply is on the B's so you would have either more ... Let me write it this way, you would have fewer A's per B. (writing) Fewer A's per B ... or you could have more B's per A. These are the same statement. (writing) More B's per A. In general, A has now become more expensive in terms of B or B has become cheaper in terms of A. Let's say you're the central bank and you say well I don't like this either. Now all of a sudden, usually this unwinding, this panic happens much faster and in more dramatic fashion than the initial phase over here. You say, oh my God people in our country they might not be able to ... If this were to happen foreign imports would become so expensive people might not be able to even afford food that we have to import from other countries or essential supplies from other countries. So they say, no, we're going to intervene. We were able to accumulate some of these foreign currency reserves so we can use those now to try to stabilize our currency. In this situation what the central bank would do is say okay I've got some reserves of A what I'm going to do is I'm going to go into the open market. I'm going to go into the open market and also sell my reserves ... and sell my reserves of A and try to equalize the supply and the demand. So, once again, if they're able to sell these reserves, now all of the sudden their currency will not devalue or maybe not devalue as much. The one kink in the system here is that they only have a finite of reserves. This right over here is finite. In the previous video when we saw that they were printing their own currency to build reserves, they could do this all day, all night because they have the right to print as much of their own currency as they want. But now they are using reserves of someone elses currency to keep their own currency from being devalued, but they can't print someone else's currency. They're hoping that what they have on hand is enough to fight this ... what they're probably perceiving is a short term imbalance, but it could be scary. What happens if all of this currency runs out? Then they blow all of their currency reserves and if this kind of panic keeps occurring then you're going to go back to the free market forces and their currency will have to devalue. That's how central banks attempt to keep their currencies relatively stable. In future videos we'll go through real cases of when this happened and what exactly happened when the foreign currency reserves ran out and how speculators could use that knowledge to essentially make an easy speculative buck.