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.

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.

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.

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.

If you have two other people 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, andshe 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. S

omeone 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.