Academic journal article The Reserve Bank of New Zealand Bulletin

A Review of the Trade Weighted Exchange Rate Index

Academic journal article The Reserve Bank of New Zealand Bulletin

A Review of the Trade Weighted Exchange Rate Index

Article excerpt

1 Introduction

The exchange rate plays an important role in the tradables sector of the New Zealand economy. Movements in the exchange rate affect both the demand and supply of exports and imports, and the New Zealand dollar prices at which these products are transacted. The rise and fall of the exchange rate against our major trading partners is therefore fundamental to the analysis of the economy.

As a small open economy, New Zealand's international transactions tend to be denominated in a range of different currencies; as a result, New Zealand faces many exchange rates and a weighted average measure of individual bilateral exchange rates against the New Zealand dollar (NZD) is necessary to summarise the country's exchange rate position. These summary measures are often referred to as an effective exchange rate or a trade weighted exchange rate index (TWI). The Reserve Bank has calculated and published a trade weighted index for New Zealand for many years and the index is widely used by analysts. At present, this TWI is based on five currencies--the Australian dollar, US dollar, UK pound, Japanese yen, and the euro.

There are many different ways to construct trade weighted indices and practices differ from country to country. Decisions need to be made on the number of currencies to include and on the most appropriate weighting methodology. These decisions depend partly on the purposes for which the TWI is being used, and partly on practical considerations such as the availability of data and computational requirements. To ensure that the index is appropriate, the Bank reviews the construction of its TWI periodically. (2)

The Bank last reviewed the TWI in 1997. This review focused on ways of better capturing the indirect link between the exchange rate and external sector competitiveness. (3) Following the review, the weighting methodology used to construct the official TWI was changed to incorporate the relative economic size of the countries included in the index, in addition to the country's weight in trade with New Zealand. The new index replaced the previous TWI that had been based on bi-lateral trade shares only. The review of the TWI also coincided with the introduction of the euro; accordingly, the euro replaced the deutschemark in the index.

This article documents a further review of the TWI undertaken over the past year. A review of the index was timely, given increasing trade flows between New Zealand and many Asian economies, the currencies of which are not captured by the five currency index. Following the latest review, the Bank has decided to begin constructing a 14 currency TWI, calculated analogously to the five currency index. This extended index will be published on the Bank's website alongside the existing five currency TWI. In both cases, the weighting methodology will be that adopted at the time of the last review.

The structure of this article is as follows: Section 2 briefly reviews the relevance of a TWI for a central bank. Section 3 considers a number of different weighting methodologies that can be used to derive effective exchange rate indices and assesses the potential pros and cons of such measures. Section 4 presents different TWIs based on variations in the number of currencies and weighting methodologies. The section also explains why the Bank has decided to continue with the existing weighting methodology when introducing the 14 currency index. Section 5 then presents some estimates of the real exchange rate--TWIs that take into account relative inflation rates or production costs of the countries concerned relative to New Zealand. In principle, these indices are more appropriate for gauging longer-term trends in New Zealand's international competitiveness. Section 6 of the article concludes.

2 What is the Reserve Bank's main interest in a TWI?

There are a number of different ways to calculate a TWI, and many purposes for which such indices may be used. …

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