Currency Effect on Trade Review

What I want to do in this post is explore how trade imbalances, in theory, should be resolved by freely floating currencies. So let's just say, that at the beginning of our time period — like we did in the last post — that the exchange rate between the Chinese Yuan and the US dollar is 10 to 1. So the last time people traded these currencies, they exchanged 10 Yuan for 1 US dollar. And, when I say "dollar," I'm going to implicitly mean the US 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. He makes dolls. So let me draw one of the 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 it in, 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, it 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 US dollar. 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 similarly to this guy in China, he needs to sell his product abroad for the equivalent of a dollar, so that he can cover shipping costs, and the manufacturing costs, and the high fructose corn syrup, and all of that. So needs to sell for 1 US dollar. 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 this current exchange rate, let's say that the demand for these dolls that there is 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 dollar — which is equivalent to 10 Yuan — then there are going to be 100 people in some time period — let's say it's a year or a 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, there is demand for 50 cans of cola in China. (Obviously, these are ridiculously low numbers, but we're just dealing with simple numbers to help our thinking.) And let me write the phrase "at current exchange rate" as well.

So what we're saying is that, in China, he needs to get a dollar. 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 of cola 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 likes 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. So let me write this down. This is China. This is the US over here. And what's the US going to do? Well, the US is going to ship over — essentially — Remember, he's selling this in the United States. So each 10 Yuan is 1 dollar. So for each doll, he's going to get 1 dollar. So he's going to get back 100 dollars for his dolls. And then, once he gets back 100 dollars for his dolls, he's going to want to convert them into Yuan. So then he will try to convert the 100 dollars 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. So we have a cola can right over there — cola. 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 in dollars — his 500 Yuan into —

Now, what's the exchange rate that he wants to get — his goal? To cover his costs, he has to get 10 to 1. So 500 Yuan into 50 dollars. 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 dollars into 1,000 Yuan. So let me write it here: 1,000 Yuan. I should have written it over here. 1000 yuan 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 US 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 dollars worth of goods to the US, while this guy is only shipping 50 dollars worth of goods to China. So there's a net trade imbalance of 50 dollars. China is shipping 50 dollars more to the US 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 post. 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 post, maybe there will be more people who want to convert Yuan, 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, but there's only 500 Yuan being sold. Or you could view it the other way. There's only demand for 50 dollars. And there's 100 dollars 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 post. 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, "Well, you know what, 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 Yuan for each of the dollars.  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 the 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 dollar. 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. Right?

 So let's think about how much his dolls cost. So his dolls, in the US, now that the Yuan has appreciated, they were 10 Yuan. And then, times — we have 1 dollar 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. One dollar and 25 cents. 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 dollar. 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 dollar. 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 a dollar, there was a demand for 100 dolls in the United States. But now that the price has gone up to $1.25. now 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, now, 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 US perspective — and shipping fewer cans of 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 is 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.