What I want to do in this video

is explore how trade imbalances, in theory, should be

resolved by freely floating currencies. So let’s just say in the

beginning of our time period, like we did in the last video,

that the exchange rate between the Chinese yuan and the

U.S. dollar is 10:1. So we have 10 yuan. So the last time people traded

these currencies, they exchanged 10 yuan for

1 U.S. dollar. And, when I say, dollar, I’m

going to implicitly mean the U.S. dollar. Now, let’s think about two

entrepreneurs in each of the countries, or one in each

of the countries. So let’s talk about a Chinese

entrepreneur. So we are in China here,

and he makes dolls. And in order to profitably sell

a doll, he needs to sell them for 10 yuan. If he’s able to sell for the

equivalent of 10 yuan in the United States– and we won’t

talk a lot about shipping and what currency you’d have to pay

and all of that– then he can pay all of his needs. Maybe even the shippers across

the Pacific, maybe their employees are also Chinese. So they want their

money in yuan. And, obviously, most of

the cost would be for manufacturing this doll. And all of his employees want

to be paid in yuan. His own rent for the factory,

or even his own rent for his own house, all has to

be paid in yuan. So this is what he needs to sell

his doll for, 10 yuan. And at the current exchange

rate, that would be $1. Now, let’s go across

the Pacific. Let’s go to the United States. And let’s say that we have

another entrepreneur who is making soda, or making

cola, for export. So let me draw a can of cola. And similar to this guy in

China, he needs to sell his product abroad for the

equivalent of $1, so that it can cover shipping costs,

manufacturing costs, and the high fructose corn syrup,

and all of that. And once again, he cares

about dollars. Because he has to pay his

own mortgage in dollars. His employees need to

be paid in dollars. Maybe the shippers he used,

they only accept dollars. So this is how both of these

characters think about it. Now, at the current exchange

rate, let’s say that there’s a demand for 100 dolls in

the United States. This guy is exporting. And so is this guy. We’ll make it very simple. They’re only focused

on exports. So at current exchange– and

I’ll do it for both– for the doll guy, there is demand

for 100 dolls in the United States. So what does that mean? That means that if he can sell

these dolls for $1, which is equivalent to 10 yuan, then

there’s going to be 100 people in some time period, let’s say

it’s a year or month, who are going to be willing to buy

the dolls at that price. And let’s say, also at this

current exchange rate, in China, 50 people are willing

to buy this cola. So at the current exchange

rate, demand for 50 cans in China. Obviously, these are

ridiculously low numbers. But we’re just dealing

with simple numbers to help our thinking. Let me write the at current

exchange rate as well. So what we’re saying is that, in

China, he needs to get $1. At the exchange rate,

that’s 10 yuan. So if he were to, at a store in

China, or to a distributor in China maybe, sell each of

these cans for 10 yuan, there’s demand for

50 cans in China. Now, what’s going

to happen here? I think some of you all might

already see that a trade imbalance is developing. So what’s going to

happen here? So this guy, he likes

doing this. And this guy like doing it. So what’s going to happen in

this time period, this Chinese guy is going to ship over 100

dolls to the United States. Let me write this down. This is China. This is the U.S. over here. And what’s the U.S.

going to do? Well, the U.S. is going to ship

over– remember, he’s selling this in the

United States. So each 10 yuan is $1. So for each doll, he’s

going to get $1. So he’s going to

get back $100. He is going to get back

$100 for his dolls. And then once he gets back $100

for his dolls, he’s going to want to convert

them into yuan. So then he will try to convert

the $100 into yuan. So this is what’ll end up

happening for this guy. And let’s say these are the

only two people trading between China and the United

States, just to really simplify things. Now let’s think about

what happens on the right side over here. This guy is going to ship

50 cola cans to China. He is going to ship 50

of them to China from the United States. And what is he going to

get back in return? Well, it’s being sold to

Chinese distributors. So they’re going to

pay him in yuan. So for each can, at the current

exchange rate, or at the current price, he’s

going to get 10 yuan. So when you convert it

back, he’s going to get 10 yuan per can. So 10 yuan times

50 is 500 yuan. 500 yuan is what he’s

going to get. And then, he’s going to try to

convert– let me write that in a different color just really

for the sake of it. So he’s going to try to convert,

because he has to pay his expenses his dollars, his

500 yuan into– Now, what’s the exchange rate that he

wants to, his goal is? To cover his costs, he

has to get 10:1. So 500 yuan into $50. And let me make it clear. This guy thinks he’s going to

get 10 yuan for every dollar. So he wants to convert his

$100 into 1,000 yuan. Let me write it here. 1,000. I should have written

it over here. So what just set up? If these are the only people

trading goods and currency in this time period, what

did we just set up? Well, clearly, this guy is

shipping more value to the U.S. than this guy is

shipping to China. There’s a trade imbalance. If you think of it in terms of

dollars, this guy is shipping $100 worth of goods to the U.S.

This guy is only shipping $50 worth of goods to China. So there’s a net trade

imbalance of $50. China is shipping $50 more to

the U.S. Then, the other way around, if you think about it

in yuan, it would be a trade imbalance of 500 yuan. And because of that, this guy is

trying to convert many more dollars into yuan than this guy

is trying to convert the other way around. Notice there is more demand

for yuan than dollars. What’s going to happen,

especially if these are the only two people trading? If these are the only two people

trading, this guy is going to say, hey,

I’ve got 10 yuan. Let me convert it

into dollars. It’ll be just like what we

saw in the last video. And, obviously, there’ll

be more actors here. But this guy has more stuff

to convert than this guy. In fact, if these were the only

two people trading, he wouldn’t even be able to

convert all of his currency into yuan. Because there’s only 500 yuan

available on the market. This guy thinks he should

get 1,000 yuan. And, obviously, if the price

of the yuan goes up, like we’ve seen in the previous

video, maybe there will be more people who want to convert

yuan, or maybe fewer people who’d want to

convert dollars. So we can think about

all of those. But I really want to think

about how this will potentially resolve the

trade imbalance. So we have a situation

with more demand for yuan than dollars. There’s a demand for

1,000 yuan here. There’s only 500 yuan

being sold. Or you could view it

the other way. There’s only demand for $50. And there’s $100 being sold. Either way there’s

an imbalance. So what’s going to happen? Well, you’re going to have

either, depending on how you want to view it– you could

say that the price of the dollar will go down. Or you could say that the price

of the yuan will go up. And the dynamics would be like

we saw in the last video. This guy over here would sell

a couple of his yuan. And he’d say, wow, there’s this

guy over there who really wants to buy it. And then maybe he’ll keep

saying, instead of giving me a dollar for every 10 of my yuan,

why don’t you give me a dollar for every 9 of my yuan? Or eventually, why don’t you

give me a dollar for every 8 of my yuan? And so he’ll keep raising

the price of the yuan. He’ll keep giving fewer

and fewer yuans for each of the dollar. Let’s say this goes on

for a little bit. And I really want to explore

the trade imbalance. Let’s say at some point– and,

obviously, maybe more and more people come into the market. So, eventually, it clears. Because, right now,

there isn’t enough yuan for this guy. But as you can see, the price

of the yuan goes up. So after all of this, because

of this trade imbalance, because more people want to

convert dollars into yuan than yuan into dollars, the

currency changes. So you could imagine– and I’m

just going to make up some numbers here– that the yuan

becomes more expensive. It was 10 yuan to the

dollar, now maybe it is 8 yuan to dollar. So this is where we

get to eventually. Because of this supply demand

imbalance right over here. 8 yuan to a dollar. Now, what’s the reality

over here? This guy over here needs to sell

his dolls for 10 yuan, which before was the

equivalent of $1. But now how much is he going

to sell his yuan for? He needs to sell for 10 yuan. That’s 8 yuan per dollar. So let’s think about how much

his dolls cost. So his dolls, in the U.S., now that the

yuan has appreciated, they were 10 yuan. And then, times– we have

$1 for every 8 yuan. So this is going to be equal

to the yuans cancel out. This is really just dimensional

analysis you might have learned in chemistry. So 10 over 8 is what? That’s 1 and 1/4. This is $1.25. Notice the price of his dolls

went up in the United States in terms of dollars. And let’s think about what

happened to the cola manufacturer right over here. So his costs, or the price he

needs to sell them for are $1. And now what’s the

exchange rate? Let me write it the other way,

because I need to cancel out the dollars. We have 8 yuan for every $1. Dollars cancel out. 8 times 1. His selling price in China

will now be 8 yuan. So notice, neither of these

people changed their prices in terms of their home currency. No change in price at all. But because of the currency

movements, because the yuan became more expensive, the

Chinese manufacturer’s goods are now more expensive

in dollars. And the American manufacturer’s

goods are now less expensive in yuan. So what’s going to happen? What’s going to happen here? At $1, there was a demand

for 100 dolls in the United States. But now that the price has gone

up to $1.25, there will only be demand at this higher

price for 50 dolls in the United States. And let’s say this

guy over here. Before, there was demand for 50

cans of his cola in China because it was 10 yuan. But now, the price

has gone down. So, now, you can imagine that

there is demand, or actually I should say there’s demand

for 50 dolls. And, now, because this guy’s

price has gone down, instead of demand for 50 cans, maybe

there’s demand for– and I’ll just make up a number–

80 cans. Maybe there’s now demand

for 80 cans. So what just happened to

the trade imbalance? Before, in terms of either

currency, we were buying more dolls, if you think about from

the U.S. perspective, and shipping fewer cola. But now, we’re buying fewer

dolls, because it’s now more expensive in the

United States. And we’re shipping more cola. So I don’t even know how

this math works. I’m going to let you

figure that out. But as one currency gets more

and more expensive, those exports, the demand for those

exports from those countries, are going to go down, like

we saw with these dolls. And on the other side, as the

other currency gets cheaper and cheaper and cheaper,

the demand for those exports will go up. Because, in other currencies,

it will look cheaper. And, eventually, you

should have some type of trade balance.