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Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket of other currencies. Although typically that basket is trade-weighted, the [[trade-weighted effective exchange rate index]] is not the |
Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket of other currencies. Although typically that basket is trade-weighted, the [[trade-weighted effective exchange rate index]] is not the only effective exchange rate index discussed in the literature. Ho(2012)proposed a new approach to compiling effective exchange rate indices. Under this approach, the effective exchange rate can be calculated as a ratio of the "normalized Exchange Value of Currency i against the US dollar" to the normalized exchange value of the "benchmark currency basket" against the US dollar. Here normalized exchange rate refers to the current exchange rate divided by the exchange rate against the US dollar in the base year. This effectively scales up the exchange rate of a "small value" currency like the Japanese Yen(which is worth a small fraction of a dollar) and scales down the exchange rate of a "big value" currency like the British pound(which is worth much more than a dollar) so that all standardized or normalized currencies in the base year are worth US$1 in the base year. The US dollar is here used as numeraire for convenience, and since it cancels out, in principle any other currency can be used instead without affecting the results. The benchmark currency basket is a GDP-weighted basket of the major fully convertible currencies of the world. Since GDP data are available with a lag, the GDP weights used in Ho(2012) are GDPs dated two years ago. The use of GDP weights has been found to be superior to direct trade weights, since countries with bigger GDPs will tend to attract imports from other countries, both direct and indirect. |
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Revision as of 09:27, 4 December 2012
Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket of other currencies. Although typically that basket is trade-weighted, the trade-weighted effective exchange rate index is not the only effective exchange rate index discussed in the literature. Ho(2012)proposed a new approach to compiling effective exchange rate indices. Under this approach, the effective exchange rate can be calculated as a ratio of the "normalized Exchange Value of Currency i against the US dollar" to the normalized exchange value of the "benchmark currency basket" against the US dollar. Here normalized exchange rate refers to the current exchange rate divided by the exchange rate against the US dollar in the base year. This effectively scales up the exchange rate of a "small value" currency like the Japanese Yen(which is worth a small fraction of a dollar) and scales down the exchange rate of a "big value" currency like the British pound(which is worth much more than a dollar) so that all standardized or normalized currencies in the base year are worth US$1 in the base year. The US dollar is here used as numeraire for convenience, and since it cancels out, in principle any other currency can be used instead without affecting the results. The benchmark currency basket is a GDP-weighted basket of the major fully convertible currencies of the world. Since GDP data are available with a lag, the GDP weights used in Ho(2012) are GDPs dated two years ago. The use of GDP weights has been found to be superior to direct trade weights, since countries with bigger GDPs will tend to attract imports from other countries, both direct and indirect.
Thus:
Value of the benchmark currency basket at time t = Σ (GDP weight of currency i(dated 2 years ago from year of time t)* normalized exchange rate of currency i against the US dollar at time t;
Effective exchange rate of currency j = Normalized exchange rate of currency j against the US dollar/ Value of the benchmark currency basket against US dollar;
Time series values of the benchmark currency basket is available from http://www.ln.edu.hk/cpps/wcu/wcu.php
Ho's procedure allows effective exchange rate indices to be easily compiled for any country.
External links
- Lok Sang Ho, "Globalization Exports,and Effective Exchange Rate Indices," Journal of International Money and Finance, Volume 31, Issue 5, September 2012, Pages 996–1007
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