The weighted average of a country's currency against other currencies
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The Trade-Weighted Exchange Rate is a complex measure of a country’s currency exchange rate. It measures the strength of a currency weighted by the amount of trade with other countries.
The Trade-Weighted Exchange Rate is largely influenced by the degree of trade carried out by one country with another. The greater the amount of trade between two countries, the larger is the effect of a change in the relative value of either currency.
The trade-weighted exchange rate is calculated by taking into consideration the weights of shares of different currencies in trade of a country whose trade-weighted exchange rate is to be calculated. Let us take the example of New Zealand.
The above graph depicts New Zealand’s trade-weighted index, taking into account 17 currencies of different countries, depending on New Zealand’s trade with them. The major trading partners of New Zealand are Australia, Japan, USA, the UK, and Germany. The trade shares of Australia, Japan, USA, the UK, and Germany are 22%, 14%, 13%, 6%, and 4%, respectively.
Calculation of Trade-Weighted Exchange Rate
Include the currency of the top five countries with which a country maintains maximum trade relations. In the case of New Zealand, this will be Australia, Japan, USA, the UK, and Germany.
Weights are assigned to each country depending on the level of its trade with New Zealand.
The index is calculated as the geometric mean, using the following formula:
(24 September 2017)
(30 May 1997)
In this case, TWI will be calculated as follows:
= (0.93/0.9013)0.2073 x (82.21/80.4348)0.0635 x (0.73/0.6910)0.1398 x (0.54/0.4216)0.0456 x (1.29/1.0822)0.0598 x 100(assumed to be 100)
= 1.0065 x 1.001 x 1.008 x 1.011 x 1.011 x 100
Problems with this Metric
In earlier times, the trade-weighted exchange rate was an effective tool in measuring the exchange rate, as most international transactions entered into by countries were on account of trade. However, with the increase in globalization, the global economy is witnessing a rapid increase in capital flows. Thus, taking into account only trade proved to be an insufficient measure.
Apart from that, there is a chance of inaccurate measurement of the exchange rate on account of undervaluation of trade between countries. Some trade may go unaccounted for by Customs officials because traders try to evade duties on goods traded. This is a major drawback in the use of the trade-weighted exchange rate.
Additionally, the trade-weighted exchange rate falls short by not taking into consideration the demand for the currency as an international reserve asset.
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