New summary measures of the foreign exchange value of the dollar

Federal Reserve Bulletin, Oct, 1998

The multilateral trade-weighted index of the foreign exchange value of the U.S. dollar against the currencies of the other countries in the Group of Ten (G-10), developed at the Federal Reserve Board in 1971, has played an important role in staff analysis of foreign influences on the U.S. economy for more than twenty-five years.(1) However, changes in international trading relationships and in the structure of international financial markets have led to increased interest in the currencies of U.S. trading partners outside the G- 10 countries. Furthermore, the establishment of the European Economic and Monetary Union (EMU) is bringing about significant changes inside the G-10 countries, with the euro, which will be introduced in January 1999, ultimately replacing five of the G-10 currencies. Consideration of these developments has prompted taking a fresh look at ways to measure the foreign exchange value of the dollar. As a result, members of the Board's staff have developed several new indexes of the dollar's overall foreign exchange value.

In general, an index of the foreign exchange value of a currency is intended to distill into a single number key information from often divergent movements in bilateral exchange rates. As with a price index, an exchange rate index can be created in a variety of ways. The design of an exchange rate index -- both which currencies to include and how to weight them -- depends on its specific purpose. Although the process of compressing individual currency information into one number inevitably results in the loss of some information, a well-designed index will preserve information that is critical for its purpose.

Exchange rate indexes can have various uses. They can play a role in the analysis of the price competitiveness of domestic goods relative to foreign goods, the effect of foreign economic and financial developments on the domestic price level, and the demand for domestic and foreign currency assets. The G-10 index, which was developed when the Bretton Woods system of fixed exchange rates first broke down, was designed to serve as a summary measure of the dollar's movements against the currencies of ten other major foreign countries that participated in the Smithsonian Accord of December 1971. Over the years, the index has been used for a variety of purposes, but it has functioned mainly as a tool in the analysis of how changes in the foreign exchange value of the dollar influence U.S. international trade. In this index, the ten bilateral dollar exchange rates are aggregated using multilateral trade shares, which are viewed as reflecting the relative importance of each country as a competitor in world markets.

Like the G-10 index, the new indexes are designed principally to measure competitiveness in world markets. However, the new indexes are created with a different weighting scheme that focuses more directly on the competitiveness of U.S. goods in U.S. and foreign markets. In addition, the new indexes summarize and characterize the dollar's movements in foreign exchange markets against a broader set of currencies and are designed to take account of the changing structure of trade patterns and exchange rates.

THE NEW INDEXES

The new indexes of the dollar's overall foreign exchange value have been developed for three currency groups, and for each group nominal and real (price-adjusted) indexes have been created. The first, and primary group is that of the currencies of important U.S. trading partners. This group is the basis for the construction of what the staff terms the broad index of the dollar's foreign exchange value. The broad index includes thirty-five currencies until the beginning of Stage III of EMU on January 1, 1999.(2) At that time. the euro will replace the ten euro-area currencies, and the broad index will have twenty-six currencies.(3)

The other two groups are subsets of the broad index currencies. One of these comprises the major international currencies -- those of the euro-area countries and Australia, Canada, Japan, Sweden, Switzerland, and the United Kingdom. These are used in the construction of what is termed the major currency index. It includes sixteen currencies until the introduction of the euro in January 1999.(4) After that, the index will become a seven-currency index.

The third group comprises the remaining currencies. In this group are the currencies of important U.S. trading partners, but these currencies are not heavily traded outside their home markets. This group is used to construct what the staff terms the other important trading partner (OITP) index. It includes the currencies of nineteen major U.S. trading partners: Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela in Latin America; China, Hong Kong, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand in Asia, Israel and Saudi Arabia in the Middle East; and Russia in Eastern Europe.

The major currency indexes -- nominal and real--have a path similar to that of the comparable G-10 indexes over the same period, although the swings in the new series are less extreme (charts 1 and 2). The nominal broad and OITP indexes move quite differently from the major currency index because of the inclusion of currencies of some high-inflation countries that have experienced persistent depreciations. The inclusion of such countries restricts the usefulness of the nominal versions of these indexes to analysis of shorter-term developments in foreign exchange markets because, over the longer term, large nominal depreciations of a few currencies swamp information on the value of the dollar against other currencies. The real versions of the broad and OITP indexes compensate for these depreciations, although the real OITP index yields a value of the dollar that is consistently higher than the value in the broad index after the mid-1980s.