Introduction to currency exchange and trade | AP Macroeconomics | Khan Academy

What I want to do in this video is think about how exchange rates can affect trade, and actually we can even think a little bit about how they might be able to affect each other, although we'll go into a lot more depth in that in future videos.

So let's just imagine a situation where the Chinese yuan depreciates versus the dollar, to be clear, U.S. dollar. To visualize what we're talking about, let's draw the supply and demand or the exchange market for the Chinese yuan. Our horizontal axis would be quantity—quantity of yuan—and then our vertical axis would be the price of yuan in terms of dollars, so dollars per yuan.

We've seen this before. This right here would be the supply of yuan, so these would be the people who are holding yuan but might be willing to exchange them into dollars. Then this would be the demand for yuan. These are the people who are holding dollars who might be interested in exchanging them for yuan. There will be some equilibrium exchange rate, let's call that e sub 1, and let's call this some equilibrium quantity per time period, let's say call that q sub 1.

And just to be clear, this is our supply curve for the yuan and this is our demand curve for the yuan. In a situation where the Chinese yuan depreciates versus the dollar, there are two ways really that this could happen. One, you could have the demand for the yuan shift to the left or you could have the supply of yuan shift to the right.

The demand shifting to the left would mean for some reason people who hold dollars are less interested in getting yuan. Supply shifting to the right would mean people who hold yuan are all of a sudden more interested in getting dollars. So actually, let's just do the latter one. Let's say the supply shifts to the right. I just want a scenario where we have the Chinese yuan depreciating against the U.S. dollar.

So you see very clearly in this world, if our demand does not shift, we get to this next equilibrium exchange rate, e sub 2, and there's also a different equilibrium quantity. But you can see that the Chinese yuan has depreciated versus the dollar. If e sub 1 is maybe 15 cents per Chinese yuan, and maybe e sub 2 is 10 cents per Chinese yuan.

Now that we understand and can visualize what we're talking about, what would be the impact on trade? I'm going to think about it in two ways. What is going to happen in China? Let's think about China first.

In China, we're going to be thinking about the Chinese consumers. Well, Chinese consumers, they hold yuan and they might buy some American goods. What would happen to the cost of those American goods? Well, assuming that the American suppliers offer their products at a fixed dollar price. So let's say you are General Motors, an American car company, and there's a car that's manufactured in the United States, and it’s twenty thousand dollars.

Well, in a world where the Chinese yuan depreciates versus the dollar, the amount of yuan to equal twenty thousand U.S. dollars has now increased. You need more yuan per dollar because you're in a world where there's fewer dollars per yuan. So, American goods are now more expensive in China.

What might that do to the behavior? How might people decide to trade off between American and Chinese, let's say in this example, cars? Well, if American goods, in this example cars, become relatively more expensive, then they are likely to buy fewer American cars. So if we're talking about all American products, we could say American imports into China will go down because they're going to be relatively more expensive.

Now, what about in the United States? What is going to happen? Well, assuming that Chinese goods are offered by the supplier at a fixed yuan price, now you need fewer dollars per yuan. So Chinese goods are going to be less expensive to American buyers.

Chinese goods are less expensive in the U.S. because each dollar is going to buy more yuan, assuming that the goods have a fixed price in yuan. You could say that Chinese imports into the U.S. are going to go up.

What's interesting is that you might have a little bit of a negative self-correcting feedback loop because what's likely to happen if American imports into China go down? Well, that means that fewer Chinese folks are going to be interested in converting their yuan into U.S. dollars in order to buy goods because they're not buying as many American goods, and so that might have the effect of shifting the supply curve back to the left.

Similarly, in a world where Chinese imports in the United States go up, well now all of a sudden more Americans will be interested in converting their dollars into yuan. So that might shift the demand curve to the right, and so that might either of these could have the effect of maybe helping the Chinese yuan appreciate a bit.

Now, in previous videos, we've talked about many factors that could shift the supply or demand curve for a currency to the right or the left. But it would be interesting to think about what would be the effects of interest rate changes in each country. And now we can link it not just to what would happen to the supply and demand curve, but we could think about how that might affect trade.

Let's imagine a situation where the U.S. government increases borrowing. We've talked about this in previous videos; that will likely lead to increased interest rates because you have a big borrower here. You could even have a crowding out effect because of the increased interest rates. Fewer private borrowers in the U.S. might borrow, but this would likely—doesn't always—increase interest rates in the U.S.

Now if you have increased rates in the U.S., what might happen for folks in China? Well, they might say, “Hey, we are more interested in holding dollars because we could in a dollar bank account all of a sudden get more interest.” So that could have the effect that we saw earlier where it could say, “Hey, more yuan holders are interested in converting into U.S. dollars.” This would shift the supply of yuan to the right, which would have the impact of depreciating the Chinese yuan, which is where we started this video.

You could see something like U.S. government borrowing, which increases interest rates, can actually have an impact on trade. It could actually make American goods less competitive in China and Chinese goods more competitive in the United States.

I just did a scenario where the supply curve shifts to the right, but you could also imagine a situation where government borrowing increasing the interest rate in the United States could even change the demand curve. Remember the demand curve is going to be determined by the sentiment from dollar holders, and how much they want to convert to the yuan.

But if interest rates in the United States go up, well now they might say, “Hey, I might want to save in the United States as opposed to investing in China or converting my money to yuan and saving in Chinese bank accounts.”

So, I'll leave you there. The big thing to appreciate here is that exchange rates and trade are very linked, and that things like government borrowing can affect interest rates, which can affect exchange rates, which can affect trade.