[youtube https://www.youtube.com/watch?v=itoNb1lb5hY&w=560&h=315]

What I want to do in thisvideo is to give you an intuitive sense of how a marketfor currencies would actually work.

And it's very non-inuitive fora lot of people because we're going to be talking aboutcurrencies becoming more expensive or cheaper, or theprice of a currency in terms of another one.

And what I want to dois give you a very intuitive feel for that.

So let's say, just because thisis a hot topic right now, let's just make the twocurrencies the Chinese renminbi and the U.

S.

dollar.

And the unit of exchange inChina is a little confusing because sometimes they use theword renminbi and sometimes the word yuan.

The yuan is the unitof the renminbi.

So let's say right now, ifI were to just go on some website– and this is not theactual exchange rate right now, but let's say right now thequoted exchange rate is 10 yuan per U.

S.

dollar.

10 yuan is equal to $1.

And every time I say dollar inthis video, I'm referring to the U.

S.

dollar.

And I think this makes sense toa lot of people, if I have $1, I want to convert it toyuan, I get 10 of them.

If I have 10 yuan, I want toconvert it to dollars, someone's going to giveme a dollar for it.

Now let's imagine a situation,and in the next few videos I'll construct actual tradeimbalances where this would actually happen, but let's saywe live in a reality where there are 1,000 yuan.

So let's say someone has1,000 yuan and wants to convert to dollars.

Now, let's say on this side, andif we just superficially looked at this 1,000 yuan andlooked 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 otheractors over here, and obviously these markets involvemany, many, more than just the three people, but thiswill help us simplify, or at least understand how theseexchange rates would work.

Let's say that this person righthere with the mustache and maybe a hat as well, let'ssay that he has $100 that he needs to convert to yuan.

Maybe he wants to buy someChinese goods, maybe he's a Chinese factory owner who soldhis goods in the U.

S.

for $100 and now he needs to convertit back to yuan to pay his employees or pay his ownmortgage or who knows what.

And let's say that there'sanother person, and let's say that she also has $100that needs to be converted into yuan.

So net, what's happening here? What's the total demand toconvert yuan into dollars, and dollars into yuan? Well, if you look at the wholemarket, you have $200 that needed to be convertedinto yuan.

Let me write this down.

We have a situation where$200 needs to be converted into yuan.

And then, on the other side ofthat transaction, we have 1,000 yuan that needs to beconverted into dollars.

So now we have 1,000 yuan.

And for simplicity, theseare the only actors.

They are representing the entiremarket, although, as we know, in *currency* marketsespecially there's thousands or even millions ofactors actively participating in them.

So what's going to happen? All of these people might justgo 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 beable to convert this $100 into 1,000 yuan, so they collectivelythink that that $200 can be convertedinto 2,000 yuan.

I'll put this inquestion marks.

So will they be able to convertthis into 2,000 yuan? And this person over here, youknow, he's saying just at the current exchange rate, maybeI'll be able to get– for my 1,000 yuan, maybeI'll get $100.

But everyone wants to maximizethe amount of the other currency they get forobvious reasons.

They want to maximize the amountof money they get.

Now, will these two people beable to convert their money into 2,000 yuan? Remember what I said, this isthe entire market, and it's a huge simplification, but thereis this imbalance here.

More dollars into yuan thanyuan into dollars.

Now they won't be able toconvert into 2,000 yuan because there's only 1,000 yuanthat wants to be traded.

So you can imagine, this guyover here, maybe he wants to do it slowly just to kind of seewhat the market is like.

So let's say at firsthe 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 forbid, and this guy's bidding on the dollar in terms of yuan, orthis guy's putting yuan up for bid and these guys are goingto bid on it in terms of dollars, either one.

And that's why it's sometimesconfusing with currencies, because you're buyinganother **currency**.

But since this guy is more indemand, to simplify things I'll make him the person that'skind of able to create an auction-type situation.

Which really is what the marketsare trying to do, so that you can equalizesupply 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 sell100 yuan for $10.

So let's say he sells100 yuan for $10.

so he sells 100– or offers Ishould say, offers to sell 100 yuan for $10, and he just thinksthat 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 justgoing to jump at that and say oh, you know what, I thinkthat's a fair price.

And so let's say this womanright over here takes it.

Actually both of them maybesaw that offer to sell 100 yuan for $10, and they both tryto click their mouse or however they're trying to makethe transaction happen.

But let's say she clicks hermouse a little faster and she gets the transaction.

So let's say that person, let'scall this person B.

And this is person A andthis 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 mymoney into yuan, but I wasn't able to.

Someone else beatme to the punch.

So this guy over here is likehey, maybe people are willing to give me more dollarsper yuan.

So let's say that this guy rightover 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 hasnow gone up, or the price of the dollar has now gonedown, either one.

Those symmetric statements,they mean the exact same thing.

So all of a sudden, this personhas a lot of dollars he needs to convert into yuan, sohe accepts really fast, so person A accepts.

I'm doing a hugeoversimplication, but it gives you the general ideato show you that this really is a market.

So person A accepts.

All of a sudden, we have anew quoted exchange rate.

We all of a sudden have anexchange rate of what is this, 9 yuan, so we have a new quotedrate or the transaction happens at 9 yuan per dollar.

Now what's happening? I think you see the dynamicthat's going to happen.

There's more dollars that needto be converted into yuan then yuan that needs to be convertedinto dollars.

So this guy actually seesthere's a lot of demand to get his 1,000 yuan.

He's going to keep offeringfewer and fewer yuan per dollar.

Or, these guys are going tostart accepting fewer and fewer yuan for eachof their dollars.

So as this happens, as the priceof the yuan will go up.

Notice, the price of theyuan went up here.

It was 10 yuan per dollar, nowit's 9 yuan per dollar.

Or you could say the price ofthe dollar has gone down.

And this will just keephappening until all of them are able to get ridof their **currency**.

There's no mathematical formulato say what the clearing price is, it's actuallydependent on how badly each of these people arewilling to transact and really how good they are atgaming each other.

But the general result here,and this is kind of what I really want you to get from thisvideo, is that because there's no law in a marketexchange rate mechanism that says this has to be the exchangerate– we'll explore how you can peg it in thefuture– but there's nothing that says that this hasto always be the case.

If there's more demand for yuanthen dollars, as we see in this example, the price ofthe dollar will go down.

Which means the exact same thingas the price of yuan will go up.

I really want you tointernalize this.

It will go up in terms ofdollars, price of dollars, in terms of yuan will go down.

And this is the crux offoreign exchange.

If you can at least internalizethese ideas and to understand that there really isthis market out here based on the supply anddemand of yuan.

Over here, the demand for yuanis exceeding its supply.

So price will go up.

Or you can view it the otherway, the demand for dollars is below its supply, so theprice will go down.

Anyway, I'll let you think aboutthat for a little bit.

In the next video, we're goingto apply this concept to see how this freely floatingexchange rate can help equalize, or should helpequalize trade imbalances in an ideal world.

Source: Youtube