Trade-weighted exchange rate indices

Overview

Trade-weighted exchange rate index.

What you need to know

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Questions from this subtopic

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1. 1

   Why is a single bilateral exchange rate an inadequate measure of a currency's value?

   Model answer

   A currency has a separate rate against every other currency, and these frequently move in opposite directions at the same time, so a currency can be falling against one partner while rising against another. Judging competitiveness from a single pair therefore gives a misleading picture, especially if that partner accounts for only a modest share of the country's trade. What matters for the economy as a whole is the average movement against all partners, weighted by how much trade is done with each.

2. 2

   What is a trade-weighted exchange rate index?

   Model answer

   A trade-weighted exchange rate index, also called an effective exchange rate, is a weighted average of a currency's bilateral exchange rates against the currencies of its trading partners, with each partner's weight reflecting its importance in that country's trade. It is expressed as an index number relative to a base period set at 100, so a value above 100 means the currency has appreciated on average since the base period and a value below 100 means it has depreciated on average.

3. 3

   Explain how the weights in a trade-weighted exchange rate index are chosen.

   Model answer

   Each partner's weight is its share of the country's total trade, calculated from exports plus imports or sometimes from exports alone, so that partners with which more business is done influence the index more. The weights must sum to one. More sophisticated versions also allow for competition in third markets, where two countries do not trade heavily with each other but compete for sales elsewhere. Weights are updated periodically as trade patterns change, since an index using out-of-date weights will misrepresent the currency's effective value.

4. 4

   A country's total trade is 100 billion pounds with country A, 60 billion with country B and 40 billion with country C. Calculate the weights for a trade-weighted index.

   Model answer

   Total trade is 100 plus 60 plus 40, which is 200 billion pounds. The weight for A is 100 divided by 200, which is 0.50; for B it is 60 divided by 200, which is 0.30; and for C it is 40 divided by 200, which is 0.20. The three weights sum to 1.00 as required.

5. 5

   Using weights of 0.50 for country A, 0.30 for country B and 0.20 for country C, and bilateral exchange rate indices of 94, 106 and 105 respectively, calculate the trade-weighted exchange rate index.

   Model answer

   Multiply each index by its weight and add: 0.50 multiplied by 94 is 47.0; 0.30 multiplied by 106 is 31.8; and 0.20 multiplied by 105 is 21.0. The sum is 47.0 plus 31.8 plus 21.0, which is 99.8. The currency has therefore depreciated by 0.2 per cent on a trade-weighted basis since the base period, despite having appreciated against two of its three partners.

6. 6

   Explain how a bilateral exchange rate is converted into an index number for use in a trade-weighted calculation.

   Model answer

   The current rate is divided by the rate in the base period and multiplied by 100. So if the pound was worth 1.20 euros in the base period and is now worth 1.14 euros, the index is 1.14 divided by 1.20 multiplied by 100, which is 95, indicating a 5 per cent depreciation against the euro. Converting each bilateral rate to an index in this way puts all the rates on a common scale so that they can be averaged, which is necessary because the raw rates are in incompatible units.

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