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Course: Finance and capital markets > Unit 8
Lesson 5: Foreign exchange and trade- Currency exchange introduction
- Currency effect on trade
- Currency effect on trade review
- Pegging the yuan
- Chinese Central Bank buying treasuries
- American-Chinese debt loop
- Debt loops rationale and effects
- China keeps peg but diversifies holdings
- Carry trade basics
- Comparing GDP among countries
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Currency effect on trade review
Currency Effect on Trade Review. Created by Sal Khan.
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A question about currency differences in general: why should ten yuan equal one dollar in the first place? Why isn't one yuan equal to one dollar? Does it have to do with inflation, i.e. the yuan is more inflated than the dollar is, so you need more of it to buy something? Or does it have something to do with trade or government regulation?(10 votes)
To answer your question "why should ten yuan equal one dollar in the first place": It also has something to the with how much value a currency have in it's own country. Imagine there are two countries which never had any contact with each other before. In one country they use currency A, in other currency B. These two countries have little in common, but they both plant apples. In one country, one apple costs 1 A, in the other country one apple costs 10 B's. So naturally, first time these two countries make contact, they would probably agree, that they would exchange 1 A for 10 B's.
From other point of view. Imagine the US government would decide they want a new currency - SuperDollar. They will start printing this new money and they will tell everybody, that they will exchange their 10 dollars for 1 SuperDollar. What happens? Well, all the prices and salaries will now be 10 times smaller (what costed 10 dollars would now be 1 SuperDollar, if you earned 10000 Dollars per month, you would now earn 1000 SuperDollars per month...) So in the end, nothing really changes, you only scratch one zero. But if you would get 10 Yuans for one dollar before, now it would be 100 Yuans for one SuperDollar. Does it mean that the american currency is all of a sudden 10 times better than it was before? No, it's just that inside the country they now use smaller numbers to describe prices of things.
But of course, the values change over time following the rules like described in this video, but you asked about how it is at the beginning...(53 votes)
Nice story - thank you.
However, balance never occurs. Aren't exchange rates, in a real market situation, constantly changing? Who decides the relative value of all the goods and services traded? And how about all the other countries trading across these goods at the same time? I know this is just an example but there appears a lot more to it than this model shows. Still, thank you for a great start.(17 votes)- its like his example happens a million times a second(6 votes)
wat happens if we all use the same currency wouldnt that be better?(2 votes)- No, because the currency reflects a countries economy. Lets say you have two countries producing similar goods (cars, computers etc.). One is bigger and richer and can effectivize its production to cut production costs and therefore becoming more competitive internationally. The 2nd country is smaller and poorer, it hence finds it harder to increase the efficiency of its production on the same scale as the larger country. To compensate for this problem it instead devalues its currency making it competitive internationally, therefore counterbalancing the more industrialized states natural advantage. Tourist countries used the same method to increase tourism. Devaluating currencies does however increase cost of imports, but that can be positive if there is a strong domestic industry and agriculture.(8 votes)
At01:06, Sal says the manufacturer ships a 100 dolls to the US, and the seller sends back $100 to the manufacturer. How then does the seller make his profits?(3 votes)- i honestly think that it does not cost a whole dollar to make a doll so the left over value is the profit but im not sure.(2 votes)
- What happens if you run a business in both china and the us, can you keep both sets of currency so you're not effected by currency market fluctuations?(1 vote)
- Yes, you may be able to pay all your bills in China with yuan that you receive as revenue in China, and all your bills in the US with dollars that you receive as revenue in US. But ultimately, you live somewhere, and you will probably want to convert your profits to your home currency. You can reduce the volatility of your foreign currency exposure but you can't eliminate it.(2 votes)
- Doesn't this scenario only work is demand is based on price only? At a certain point there will be a negligible increase in the demand for cola for a reduction in price. Let's say that the increase in demand for cola (or the entire basket of US goods) approaches zero as the demand approaches 70 cans, and that because the dolls (or the Chinese basket of goods) are so massively popular, the demand for the dolls approaches 4 as the price of doll rises even to very high prices (think of those Elmo dolls everyone was fighting for) then wouldn't there still be a trade gap even though there are floating exchange rates. In very simple terms- what if Chinese products are more attractive to the US than the other way around?(2 votes)
If the author in the last bit; instead of 60 dolls demand in US and 75 colas' demand in China, used another set of values, say 54 dolls and 93 colas.
Then the trade balance would not work out.
How do you know by how much the demand is expected to change ?(2 votes)- Aren't trade contracts negotiated in USD, usually? So the Chinese convert to USD in China .(2 votes)
- Yes, it's not that hard to find out how much of their currency is worth in US dollars. But anyways, trade is not done in just cash, especially US dollars. Trade is done with imports/exports and if they use any currency, it will be the globally accepted gold. Money really only resembles the value of what it took to get it ( a good or a service), and that value may be paid off in a different way.(1 vote)
but the question is, iff he exchanges 100 $ into yuan, but there is not such amount of yuan, the yuan will rise in its value, lets say he gets 80 yuan for it, but will the inland prices get down as much as the value of the yuan is changing? I mean if you bought 1 bread for 1 yuan, and the price for yuan has risen, so you get 800 yuan for 100 dollars, will bread still cost 1 yuan or 0.8 yuan? -because if the prices were still the same, you would actually have less money to spend than before...
how is market adapting that fast to the price??(1 vote)
The market rarely changes at extreme rates like 20%; it's more like 1%-5% of difference annually, with a tendency towards balancing itself. Companies usually feel these effects before any consumer would and they can decide how to handle it. Wal-Mart may sneakily charge 3 cents extra on one popular good, effectively offsetting the extra 1% to all goods cost, and allow bread to remain the same price. Or they might not bother with it at all, since they'll make it back next year when the exchange rates tilt towards their favor. Oil prices, on the other hand, fluctuate almost daily based on market exchange rates.(3 votes)
If trading currencies are rather complicated, why can't the whole world use the same currency? What would happen if the world uses the same currency?(1 vote)
The only way the whole world will use one currency is either if all the nations become one, an alien invasion hits and we have to band together for centuries, or if the private bankers managed to take over the world in a new world order.(3 votes)
01:06Video transcript
Let's review what happened in
the last video because, in general, it's just kind of
confusing and it's always good to see it a second time. And then we can think a little
bit about how these market dynamics could be manipulated
so that you don't have the Chinese currency getting
more expensive. So the last video, we started
off with an exchange rate of CNY 10 per dollar. We saw that this manufacturer
over here in China had to sell his goods for the equivalent of
CNY 10 in order for him to make a profit and that this guy
in United States had to sell his goods abroad-- or we'll
say in China-- for the equivalent of $1. Now it's this exchange rate,
this price was $1 and at this exchange rate, this guy had to
sell his cola for CNY 10 so that he could get his dollar. So we kind of just
drew it out. And we said at that price, so
for CNY 10 which was $1, at $1 there was demand for 100 dolls
in the United States. So we saw this dynamic,. He would ship 100 dolls to the
United States and then the United States would ship
him back $100. He would sell those dolls for
essentially $1 each, he would get back $100. On the other side of the
equation, the cola manufacturer, if he were to sell
it for CNY 10 in China, there's demand for
50 cans of soda. So he would send 50 cans of soda
to China and they would send them CNY 10 for
each can, CNY 500. Now, what happened in that
situation is that the Chinese manufacturer had CNY 1,000 that
he needs to convert into dollars, into $100 preferably,
if that exchange rate were fixed. The American manufacturer, and
let's say that these are the only two actors in our scenario,
has CNY 500 that he needs to convert into $50. So if we just look over here,
here's someone who wants to convert CNY 1,000. Or he wants to convert
into CNY 1,000, let me be very careful. He wants to convert his $100
into CNY 1,000 if the currency were to be held constant. But there's only CNY 500 being
offered in the market. So he was going to have to offer
more dollars per Yuan then he would if there was
more Yuan in the market. Now you can look at it
from the other side. This American manufacturer
has CNY 500 from his sales in China. He wants to convert it if the
currency was pegged into $50, but maybe he could do better
than $50 here. And as we can see, there's more
demand to convert the Yuan than there is to
convert the dollars. He wants to buy $50
using Yuan. This guy wants to sell
$100 into Yuan. So if you look over here, the
supply of dollars is much greater than the demand
for dollars. And you know in anything, if
the supply of apples is greater than the demand for
apples, then the price of apples would go down. And the opposite is happening
here with the Yuan. The demand for Yuan-- this is
the demand-- is much greater then the supply of Yuan. And we know that when the demand
is greater than the supply, the price
needs to go up. And so we saw a scenario where
the price of the dollar will go down in terms of Yuan. Now all that means is if you
have to give CNY 10 per dollar, now you're going
to have to give fewer Yuan per dollar. The price of Yuan
would go down. If the price of apples in Yuan
goes down, instead of offering CNY 10 per apple,
you'd probably offer CNY 8 per apple. So we see the exact same thing
for the price of the dollar. But that's equivalent
to saying the price of a Yuan goes up. Now we said eventually, and I'm
just making this number up, it's hard to predict what
the actual settling price would be, we eventually get
to CNY 8 per dollar. And then we said, at that
exchange-- and actually I'm going to change the numbers a
little bit just to make it a little bi cleaner-- at that
exchange rate, at CNY 8 per dollar, these 10-Yuan dolls
would now cost $1.25. And let's say that at $1.25, in
the United States, there is a demand for 60 dolls. I'm changing the numbers a
little bit from the last video just to make the numbers work
out a little bit better. So you can just ignore the
numbers from the last video. And remember, the older demand
when the 10-Yuan dolls were only $1, so the old demand
was 100 dolls. So it makes sense. If dolls are $1, people are
going to have more of them. If dolls go up to $1.25, the
demand will go down and say they'll go down to 60 dolls. Now on the other side of the
equation, the $1 can of soda at CNY 8 per dollar will now
sell in China for CNY 8. And remember what the
old price was. The old price in China where the
currency rate was 10 to 1 was CNY 10. So the price-- let me write it
here-- the price the cola went from CNY 10 down to CNY 8. So the demand, now that the cola
is cheaper in China, the demand went up. And I'll change this number too,
so don't do the 80 cans. We'll say that the demand in
China went from 50 cans, we saw that up here-- he had to
ship 50 cans when it cost CNY 10 per can-- So it went from 50
cans up to-- maybe I make it go up-- the demand
went from 50 up to, let's say, 75 cans. I'm using these numbers because
it's going to lead to cleaner numbers. So now what is the
actual scenario? In the last video I said work it
out yourself, but I realize the more concrete examples of
this, the more it will kind of sink into your brain. So now what is the trade
balance going on? So going from China, and then
you have the U.S. Over here we're going to be shipping
60 dolls. And then the U.S. is going to
ship back 60 times $1.25, that is $75, right? $1.25 for
60 dolls means you're going to get $75. So $75 is going to
go back to China. So that's due to the dolls,
and now let's think about what's going to happen
due to the soda. We are going to have 75 cans
of soda are going to be shipped to China and then China
is going to send back 75 cans at CNY 8 per can. 75 times 8, 600. So for the 75 cans, he is going
to get back CNY 600. So now what's happening? The Chinese manufacturer over
here on the left wants to convert $75 into-- if we assume
that the currency is now eight, and he says, well,
I'll just it get at the market rate-- into roughly CNY 600. 75 times 8 is 600. CNY 8 per dollar. And then the U.S. manufacturer
wants to convert-- He's got CNY 600 from his sale of soda
and, if he assumes he can get kind of the last market rate,
600 divided by 8 is into $75. So what just happened here? Now the supply of dollars
is equal to the demand for dollars. And also, the supply of Yuan
right over here is equal to the demand for Yuan. So now, depending on how you
view it, we're sending the same dollar value to the U.S.
as we're sending back to China, or we're sending the same
Yuan value to the U.S. as we're sending back to China. And the currency is
now in balance. It really shouldn't shift. So I really wanted to go through
this example again to show you that when you have
freely floating currencies, eventually one currency should
get more-- if there is a trade imbalance-- expensive than the
other until the demand equalizes in both countries so
that you eventually do have a trade balance. Hopefully that doesn't confuse
you too much, and in the next video, we'll talk about how a
government-- and we'll talk about the Chinese Central Bank
in particular-- could intervene so that this doesn't
happen, so that they can always ship more to the U.S.
than the U.S. ships to China.