Understanding the Market for Currencies

Introduction

• Focus on conceptualizing currency markets.
• Discuss currencies becoming more expensive or cheaper.
• Example currencies: Chinese Renminbi (Yuan) and US Dollar.

Basic Concept of Exchange Rates

• Quoted exchange rate: 10 Yuan per US Dollar
  • Conversion: $1 = 10 Yuan or 10 Yuan = $1

Simplified Market Scenario

• Actors in the market:
  • Person with 1000 Yuan wants to convert to Dollars.
  • Two people with $100 each want to convert to Yuan.
• Total demand:
  • $200 need to be converted into Yuan.
  • 1000 Yuan need to be converted into Dollars.

Market Dynamics

• Imbalance: More dollars to be converted into Yuan than Yuan into Dollars.
• Currency conversion bids:
  • Person with Yuan can create an auction-type situation.
  • Offers to sell 100 Yuan for $10 initially.
  • One person accepts this offer quickly.

Impact on Exchange Rates

• Sequence of events leads to changes in exchange rates:
  • Initial rate: 10 Yuan per Dollar.
  • New rate after transactions: 9 Yuan per Dollar (indicating Yuan becomes more expensive).
• More demand for Yuan than supply makes its price go up, and vice versa for Dollars.

Key Takeaways

• Foreign exchange markets are based on supply and demand.
• No fixed law on exchange rates; they fluctuate based on market dynamics.
• Understanding the demand and supply balance helps in grasping how currency values change.

Conclusion

• Exchange rates help in balancing trade imbalances.
• Further exploration to peg exchange rates will be discussed in future sessions.