Economics – Exchange rates | e-Consult

Calculation of Trade-Weighted Exchange Rate:

1. Calculate the percentage of a country's total exports that are traded with a specific country. This is done by dividing the value of exports to that country by the country's total exports and multiplying by 100.
2. Calculate the percentage of a country's total imports that are sourced from a specific country. This is done by dividing the value of imports from that country by the country's total imports and multiplying by 100.
3. Subtract the percentage of imports from the percentage of exports. This difference represents the trade balance between the two countries.
4. Repeat steps 1-3 for all relevant trading partners.
5. Calculate the average of all the trade balance percentages. This average is the trade-weighted exchange rate. The trade-weighted exchange rate is often expressed as a number between 0 and 1, where 1 indicates the currency is strongly valued and 0 indicates it is poorly valued.

Advantages of using the trade-weighted exchange rate:

• Reflects actual trading activity: It directly measures the relative strength of a currency based on its real-world trading partners, providing a more practical measure than nominal exchange rates.

Disadvantages of using the trade-weighted exchange rate:

• Doesn't account for all trade: It only considers the value of traded goods and services, ignoring other forms of international financial flows such as foreign direct investment (FDI) or portfolio investment. A country with large FDI might have a trade-weighted rate that doesn't accurately reflect its currency's strength.