# Currency Exchange Introduction

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.