Supply and demand curves in foreign exchange | AP Macroeconomics | Khan Academy

In a previous video, we've given an intuition on what foreign exchange markets are all about. In particular, we talked about the foreign exchange market between the U.S. dollar and the Chinese yuan.

What we're going to do in this video is think about the same idea but think about it in terms of graphs and the types of economic models that we're used to seeing in an introductory macroeconomics course. So, what we're going to focus on in this video is the foreign exchange market for the Chinese yuan.

Now we're going to think about it in terms of supply and demand curves. It can be a little bit confusing because we're going to be thinking of the price of the yuan in terms of another currency, in this case, the dollar, although you could do it in terms of other currencies like the pound, the euro, or whatever else.

Now, this can be a little bit confusing because we're going to be thinking about currency on both axes. But let's first think about the horizontal axis. When we're thinking about most markets, that is our quantity axis. Here, once again, we want to think about quantity. We're going to think about the quantity of Chinese yuan.

Then, on our vertical axis, we're essentially going to be thinking about the price of the Chinese yuan. But how do you think about the price of a currency? Well, we're going to think of it in terms of another currency. For the sake of this video, that other currency is going to be the U.S. dollar. So, this is going to be U.S. dollars per Chinese yuan.

I encourage you to pause this video and think deeply about why it’s U.S. dollars per Chinese yuan as opposed to Chinese yuan per U.S. dollars. Think about why I put the quantity of Chinese yuan here instead of the quantity of U.S. dollars because this is the foreign exchange market for the Chinese yuan.

I could have done another chart where it’s the foreign exchange market for the U.S. dollar, in which case then my quantity would be U.S. dollars, and then I would think of how much of some other currency per U.S. dollar. So I would say maybe how much Chinese yuan per U.S. dollar, but here it's the other way around. I'm in the market for the Chinese yuan.

So, let’s think about the supply and demand curves and which way they would work. Well, imagine that people are offering very few U.S. dollars per Chinese yuan. Well, in that world, a lot of people might not want to convert their yuan into dollars. They might not offer them up for supply to be converted into U.S. dollars, and so the quantity of Chinese yuan, if the price for the Chinese yuan is low, might be pretty low.

As the price people are willing to pay in terms of dollars goes up, well, more and more people might be willing to transact. So, our supply curve, and here we're talking about the supply for Chinese yuan, is likely to increase as people are willing to pay more for those yuan. This is like many markets that we've seen before. This is just a little bit less intuitive because we're thinking about markets for one currency in terms of another currency.

Now, what about the demand curve? Well, the demand curve is going to look like a lot of demand curves we've seen. If the price of a Chinese yuan is high, very few people are going to demand it. As the price of the Chinese yuan in terms of dollars is lower and lower, more and more people might demand more Chinese yuan because, hey, it’s cheaper now in terms of U.S. dollars.

So, this is what a demand curve might look like, and as you could imagine, this point is our equilibrium point. It would tell us our equilibrium exchange rate, and we could call that our equilibrium exchange rate. This would be our equilibrium quantity.

For example, let's say that our equilibrium quantity, and let's say this is the quantity that changes hands in some time period—so, let's say per day. Let’s say our equilibrium quantity is equal to 1,001. Let me just call this q sub 1, which is 1,001. These numbers are very low. In real exchange markets, we might be talking about billions or tens or hundreds of billions or even sometimes trillions of various currencies.

But let's just say for argument’s sake that 1,000 yuan is our current equilibrium exchange quantity per day. Let’s say this exchange rate, e sub 1, is equal to 10 cents per yuan, so 10 cents or one-tenth of a U.S. dollar per Chinese yuan. So, that's our current exchange rate.

Now, let’s say for some reason all of a sudden Americans are very, become increasingly interested in converting their currency. Maybe they want to invest in China. Maybe all of a sudden the Chinese say, “Hey Americans, come buy property in China!” A lot of people are interested.

Well, what would happen here? Well, then the demand for yuan would increase because you could only buy that property in China with yuan, not with U.S. dollars. So, what would happen here? Well, your demand curve would shift to the right, like we've seen before. If we call this d1, then we could get to a new demand curve that might look something like this d2.

Now, what would happen if our equilibrium exchange rate doesn’t change? Well, if this is our exchange rate, if this were to stay our exchange rate, now all of a sudden a higher quantity is being demanded than is being supplied.

The Americans in this situation, or it actually doesn't even have to be Americans; it could just be whoever's holding U.S. dollars. There's demand for more than 1,000 yuan per day. Maybe this is 1,500 yuan or whatever it might be. So, what you would naturally see is that the price of the yuan in terms of U.S. dollars will go up until you get to an equilibrium point.

In the first video, when we talked about the intuition of foreign exchange markets, we discussed why this would be so. You would then get to a new equilibrium right over here. This is e sub 2 and a new equilibrium quantity.

Let’s call this q2. Our new equilibrium quantity, q2, might be 1,200 yuan per day versus 1,001 per day. Our new equilibrium exchange rate maybe this is now equal to 15 cents per yuan instead of 10 cents per yuan.

So, big picture, you can think of the foreign exchange market in a lot of ways like we've looked at other markets in macroeconomics. It's just that it takes a little bit of an intuitive leap to just think about the market for one currency in terms of another.