Narrator: In the last video we saw how
everyone in country A got excited about investing
in country B and so they wanted to convert their
currency into country B's currency.
Left to its own devices with this new demand
for currency B, it would have made currency B
more expensive, but instead of allowing that
to happen the central bank of country B
said no, no, no, no, no, I want to keep the
exchange rates relatively stable,
so I'm going to print B's and use those to buy
up A's.
So at the end of that video the central bank of
country B ended up with foreign currency reserves.
It ended up with some of A's currency
on its balance sheet.
What I want to do in this video is think about
what if demand goes the other way
and how could the central bank use its foreign
currency reserves to prevent its currency
from devaluing.
Let's go to the next stage in our little
hypothetical story here.
Let's say people in A, all of this investment
happened in country B, everyone was all excited.
Probably a bubble was forming of some kind
and then all of the sudden the investors
in country A start to get a little bit scared.
They start to hear reports of the bubble forming,
they start to realize that conditions in country B
weren't as good as they thought it might
have been initially, so they start to panic.
They start wanting to unwind their investments.
Whatever they had in country B they want to sell it,
they get B's currency for it and they want to
convert that to their home currency.
Now you have the reverse situation
of what we saw in the last video.
Everyone wants to sell their B's,
so they had invested in country B
maybe they had bought some real estate there,
they're going to sell their real estate,
they're going to get B's for it
and then they're going to get out of that
countries currency.
They're going to want to convert that money
back in to A's, but this is the opposite situation.
Now everyone wants to run out of country B
and there isn't a lot of supply of A's in return.
No one's really looking to trade A's for B's now.
Everyone is irked, the market is going completely
in the opposite direction.
If, once again, foreign exchange markets
were allowed to float freely what would happen?
In this situation all the demand is for the A's
and all the supply is on the B's
so you would have either more ...
Let me write it this way, you would have fewer
A's per B.
(writing) Fewer A's per B
... or you could have more B's per A.
These are the same statement.
(writing) More B's per A.
In general, A has now become more expensive
in terms of B or B has become cheaper in terms of A.
Let's say you're the central bank
and you say well I don't like this either.
Now all of a sudden, usually this unwinding,
this panic happens much faster
and in more dramatic fashion than the initial
phase over here.
You say, oh my God people in our country
they might not be able to ...
If this were to happen foreign imports would become
so expensive people might not be able to even
afford food that we have to import from
other countries or essential supplies
from other countries.
So they say, no, we're going to intervene.
We were able to accumulate some of these
foreign currency reserves so we can use those
now to try to stabilize our currency.
In this situation what the central bank would do
is say okay I've got some reserves of A
what I'm going to do is I'm going to go
into the open market.
I'm going to go into the open market
and also sell my reserves ...
and sell my reserves of A and try to equalize
the supply and the demand.
So, once again, if they're able to sell these
reserves, now all of the sudden their currency
will not devalue or maybe not devalue as much.
The one kink in the system here is that they only
have a finite of reserves.
This right over here is finite.
In the previous video when we saw that they were
printing their own currency to build reserves,
they could do this all day, all night
because they have the right to print as much
of their own currency as they want.
But now they are using reserves of someone elses
currency to keep their own currency from
being devalued, but they can't print someone
else's currency.
They're hoping that what they have on hand
is enough to fight this ... what they're probably
perceiving is a short term imbalance,
but it could be scary.
What happens if all of this currency runs out?
Then they blow all of their currency reserves
and if this kind of panic keeps occurring
then you're going to go back to the free market
forces and their currency will have to devalue.
That's how central banks attempt to keep
their currencies relatively stable.
In future videos we'll go through real
cases of when this happened
and what exactly happened when the foreign
currency reserves ran out and how speculators
could use that knowledge to essentially make
an easy speculative buck.