An Indicator of Effective Exchange Rates

IT IS A FAMILIAR PROPOSITION that changes in a country’s own par value, or in its exchange rate as customarily expressed in terms of a single other currency, give only a partial indication of the economically significant movements in its exchange rate. This comes most conspicuously into view when major adjustments in par values are made in the same direction by a number of countries at the same time. It is then apparent that these parallel adjustments in some degree qualify or dilute each other. Thus, the devaluation of sterling along with numerous other currencies in September 1949, and the devaluation of sterling along with a smaller number of other currencies in November 1967, occasioned calculations of the “effective,” as distinct from the nominal, adjustments that resulted for the currencies concerned, taking into account the impact of the concurrent nominal rate changes for the other currencies.1 Clearly, however, mutual influence of this kind is not confined to such par value changes as happen to be concurrent. The effective exchange rate of any single currency is always influenced by changes in the exchange rate, as customarily expressed, of other currencies, whether these changes are large or small, and whatever their timing.

Abstract

IT IS A FAMILIAR PROPOSITION that changes in a country’s own par value, or in its exchange rate as customarily expressed in terms of a single other currency, give only a partial indication of the economically significant movements in its exchange rate. This comes most conspicuously into view when major adjustments in par values are made in the same direction by a number of countries at the same time. It is then apparent that these parallel adjustments in some degree qualify or dilute each other. Thus, the devaluation of sterling along with numerous other currencies in September 1949, and the devaluation of sterling along with a smaller number of other currencies in November 1967, occasioned calculations of the “effective,” as distinct from the nominal, adjustments that resulted for the currencies concerned, taking into account the impact of the concurrent nominal rate changes for the other currencies.1 Clearly, however, mutual influence of this kind is not confined to such par value changes as happen to be concurrent. The effective exchange rate of any single currency is always influenced by changes in the exchange rate, as customarily expressed, of other currencies, whether these changes are large or small, and whatever their timing.

IT IS A FAMILIAR PROPOSITION that changes in a country’s own par value, or in its exchange rate as customarily expressed in terms of a single other currency, give only a partial indication of the economically significant movements in its exchange rate. This comes most conspicuously into view when major adjustments in par values are made in the same direction by a number of countries at the same time. It is then apparent that these parallel adjustments in some degree qualify or dilute each other. Thus, the devaluation of sterling along with numerous other currencies in September 1949, and the devaluation of sterling along with a smaller number of other currencies in November 1967, occasioned calculations of the “effective,” as distinct from the nominal, adjustments that resulted for the currencies concerned, taking into account the impact of the concurrent nominal rate changes for the other currencies.1 Clearly, however, mutual influence of this kind is not confined to such par value changes as happen to be concurrent. The effective exchange rate of any single currency is always influenced by changes in the exchange rate, as customarily expressed, of other currencies, whether these changes are large or small, and whatever their timing.

This statistical truism has recently gained increased recognition in analysis of exchange rate developments, and it has a bearing on certain aspects of proposals for changes in the existing exchange rate regime. The purpose of this paper is to provide a statistical measure of past changes in effective exchange rates of major currencies over a continuous recent period and to discuss briefly the significance of the results shown. Particular attention is paid to the relationship between the indirect influence on effective exchange rates resulting from exchange adjustments of other currencies and the direct influence resulting from adjustments in the given currency. The movement in the effective exchange rate is also observed as an indicator of whether, from the standpoint of particular currencies, the changes in parities of other currencies have involved a devaluation bias or a revaluation bias: contrary to some general impressions, no general devaluation bias is found in the system as a whole. The methodology is extremely simple and would be open to a number of refinements if this were considered worthwhile.

I. Concepts

Since World War II, with rare exceptions, the exchange rate of any particular currency has come to be expressed in terms of a single denominator, or numeraire. This is in part a matter of law: Article IV, Section 1(a), of the Fund’s Articles of Agreement requires that “The par value of the currency of each member shall be expressed in terms of gold as a common denominator or in terms of the United States dollar of the weight and fineness in effect on July 1, 1944.” Beyond this, the expression of a country’s exchange rate in terms of a single other currency has obvious advantages of convenience. It reflects, at any point of time, the relationship of the given currency to all other currencies, and reflects such changes in this relationship as result from changes in the value of the given currency itself against the numeraire. In addition, where, as is usually true, the numeraire currency is also the intervention currency (i.e., the currency against which the value of the given currency is regulated in the exchange markets), the exchange rate against this intervention currency will have a singular operational importance.

For a number of analytical purposes, however, the exchange rate of a currency should reflect the evolving relationship between that currency and all other currencies. This may be true, for example, for the purpose of assessing the impact of changes in the exchange rate and in other factors on competitiveness and export performance. In such a context, the exchange rate expressed in terms of a single denominator—hereafter referred to as the numeraire exchange rate—can be no more than a proxy for the development of the total relationship between the given currency and all others. In this paper this latter relationship will be termed “the effective exchange rate.” The concept of the effective exchange rate, unlike the numeraire exchange rate, can also be applied to the numeraire currency itself.

The concept of the effective exchange rate cannot be expressed in absolute terms and has no significance at any point of time. Thus, while the parity2 of the pound sterling is currently $2.40, there is no way of expressing its effective parity against all currencies by relating $2.40 to its equivalent in deutsche mark, francs, guilders, etc., to arrive at some composite effective exchange rate. Over time, however, the numeraire exchange rate, as noted above, reflects only such changes in the value of the given currency against the totality of other currencies as result from changes in its own value against its numeraire. The effective exchange rate will be influenced in addition by changes in the value of other currencies in terms of their numeraire, which will of course change the value of these currencies in terms of the given currency. This second, indirect component of influences on the effective exchange rate will reflect the composite change in the numeraire exchange rates of other currencies, calculated with appropriate weights reflecting the relative importance of the different currencies for the total relationship of the given currency to other currencies. The criterion on which this relative importance should be based will depend in part on the analytical purpose for which the concept of the effective exchange rate is employed. As an influence on competitiveness in international trade, it may most appropriately be based on some indicator of relative trade shares.

The effective exchange rate movement of any given currency may then be taken as the percentage “direct” change in its numeraire rate minus the weighted percentage “indirect” change in the numeraire rates of other currencies. (There will be no “direct” effects for the numeraire currency, and the proportionate indirect change is the only constituent of the movement in the effective exchange rate.) Thus, the change in the effective exchange rate of a currency where, e.g., the dollar is numeraire is taken as equal to the percentage change in its dollar rate minus the weighted aggregate of percentage changes in dollar rates of other currencies.3

In the limiting case, a proportionate composite change in the indirect component of a given percentage amount will exert the same impact on the effective exchange rate as a “direct” change of similar size in the numeraire exchange rate. In practice, however, the indirect influence will be diluted to the extent that numeraire rates of other currencies show zero changes. This will, for example, always be true for the numeraire currency itself. The larger the weight4 of the numeraire currency and of currencies whose numeraire rates show no change, the smaller will be the differences between movements in the effective exchange rate and the numeraire rate of the given currency.

This factor tends to reinforce a general tendency for the indirect influence on effective exchange rates for currencies, generally and over time, to be relatively weak. Insofar as other numeraire exchange rates show random movements and no particular trend vis-à-vis the given currency, there is a natural tendency for the effective exchange rate, over time, to move closely in line with a country’s numeraire exchange rate. The calculations in this study confirm this general tendency. In the following cases, however, these considerations will not apply so strongly, or at all, and it is here that the effective exchange rate is a significant indicator: (1) where the numeraire rate of a currency shows a tendency, either persistently or for short periods, to diverge from changes in numeraire rates of closely related currencies; (2) where payments disequilibria in the given currency have a sufficient impact on other countries to contribute significantly to exchange adjustments in those countries, as well as (or even in place of) inducing direct exchange adjustments in the given country; (3) for the numeraire currency itself, which may be considered as an extreme example of case (2).

II. Methodology

The Currencies Selected

In this study, the examination is confined to movements in terms of each other of the currencies of the 14 countries classified in the International Monetary Fund’s publication, International Financial Statistics (IFS), as industrial countries (see Table 1). The reason for this selection is in part practical: confining the study to these 14 countries that account for more than 70 per cent of total international trade recorded in IFS5 makes the analysis notably more manageable than it would be if extended to the 70 or so currencies for which records of distinctive individual exchange rate movements6 are available. But some selection comparable to that chosen here would be desirable in any case. The analytical indicator of the effective exchange rate constructed here is designed mainly to illustrate one particular influence—that emanating from exchange rate changes—on international competitiveness. It follows that the countries whose mutual exchange rate relationships are being measured should (1) compete with each other to a significant extent and (2) not have had the influence of the mutual exchange rate relationship on their competitiveness dwarfed by some extraneous factor, of which perhaps the most important example is a widely different rate of inflation. If the group were to be extended outside the industrial countries, an intrusion of this kind would, however, occur. This is reflected in a calculation that in the period 1948–68 and among a different group of 14 countries the effective exchange rate of the U.S. dollar appreciated by some 375 per cent: all but 39 per cent of this reflecting the successive devaluations of one country in the group, Brazil.7 Exclusion of countries experiencing very large cumulative changes in exchange rates in this study permits the use of a simple formula (see footnote 3).

Table 1.

Trade Matrix, 19671

(Change of 1 per cent (+ or —) in dollar exchange rate of country in stub denotes change of indicated fraction of 1 per cent (— or +) in effective exchange rate of country in heading)

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Source: Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

Showing the proportion of trade in manufactures (exports plus imports) of country in heading with country in stub, in relation to former country’s trade in manufactures with 13 countries combined. The proportion is expressed so as to sum to 1 per cent; if the decimal points are dropped, the figures may be read as percentages.

Choice of Weights

The weights to be applied to movements in each country’s numeraire exchange rate in its impact on other countries’ effective rates could be determined by a number of criteria. The choice here also has been guided by the objective of indicating the influence of exchange rate movements on competitiveness in international trade (among other influences on competitiveness). There is of course no ideal way of selecting the trade weights for this purpose. In this paper, the basis chosen is the pattern of trade in manufactured goods within the group of industrial countries, ignoring both intragroup trade in nonmanufactures and trade relationships extending beyond the group. The effect on a given country of a change in the numeraire rate of another country within the group is related to its trade in manufactures with the latter country, relative to the given country’s trade in manufactures with the group as a whole. This reflects the view that a country’s exposure to a change in competitiveness of competing countries depends not only on the size of those countries in the world market or the group market as a whole but also on their share in the exports from and the imports to the given country—shares that will of course usually bear some relation to their size in the world market.8

For each of the 14 countries, an index of effective exchange rate movements has been constructed in accordance with the formula in footnote 3. The weights applied to the U.S. dollar exchange rates of the other 13 countries reflect the share of each of these countries in the given country’s exports of manufactures to and imports of manufactures from the 13 other countries combined. These relative shares have been read from trade matrices compiled for trade data in 1951 (used as weights for the years 1949–55), 1959 (used for 1955–63), and 1967 (used for 1963–69). These weights are shown in Tables 1, 6, and 7. The figures in Table 1 indicate the shares, as proportions of 1 per cent, on the above basis in 1967; the figures thereby indicate the impact on the effective exchange rates of any one of the 14 countries of a change of 1 per cent in the respective dollar rate of any of the other 13 countries.

The table may be used as a rough, general guide to the cross effect of a devaluation or revaluation by one country on other countries of the group. Thus, reading vertically, for Belgium, Canada has a weight of 1 per cent (indicating that Canada’s share of Belgium’s exports of manufactures to it and to the 12 other countries, and its share of Belgium’s imports of manufactures from it and from the 12 other countries, averages 1 per cent); France has a weight of 19 per cent on the same criterion, Germany a weight of 27 per cent, etc., to a total of 100 per cent for the 13 countries. These weights govern the impact of changes in the U.S. dollar exchange rate of the countries listed in the stub on Belgium’s effective exchange rate. The table says that if Germany’s dollar exchange rate appreciates by 1 per cent, this indicates a depreciation of 0.27 per cent in Belgium’s effective rate, on the basis of trade relationships in 1967; whereas a 1 per cent appreciation in the U.S. dollar rate of the Canadian dollar, by comparison, indicates a depreciation of only 0.01 per cent in the Belgian franc because of Canada’s smaller relative importance in Belgian trade. The difference in the U.S. trade pattern leads to a reversal in this relative importance of these two currencies in this respect: the U.S. dollar shows an effective depreciation of only 0.11 per cent on a 1 per cent appreciation of the deutsche mark but of 0.40 per cent on a 1 per cent appreciation of the Canadian dollar. Thus, each country’s weight differs in respect of the effective exchange rate of each other currency, as well as differing somewhat among the same countries over time. This latter influence reflects the shifts in trade patterns over time, which have, however, been relatively small. It may be recalled that for each of the countries the weights attached to the dollar exchange rates of the 13 other countries sum to unity: i.e., if 13 of the currencies all appreciate or depreciate by a uniform amount, this indicates an equivalent depreciation or appreciation of the remaining currency in the group.

Weights have been applied on this basis to the percentage change of (1) the monthly average spot exchange rate of each of the 14 currencies against the U.S. dollar from January 1949 to December 1969, taking the rate of the U.S. dollar itself as unity; (2) the parity of each of the 14 currencies from January 1, 1959 to December 31, 1969; for the period during which the parity of the Canadian dollar was inoperative (September 30, 1950-May 2, 1962), the average monthly market rate has been substituted for the parity. The resulting computations are referred to as, respectively, the effective market rate and the effective parity rate.

III. Interpretation

The movement in effective market rates of four of these currencies in 1949–69, together with the movement in the market rates against the U.S. dollar—and, for the U.S. dollar, the effective market rate—are shown quarterly in Chart 1; similar calculations have been made for the nine other currencies. For the general reasons mentioned on page 456, the movements in the effective rates show little distinctive movement for most currencies for most of the time. The main exception, over the period as a whole, is of course the U.S. dollar, in its special position as numeraire currency. A smaller exception is the deutsche mark (Chart 1). The effective exchange rate of the deutsche mark shows over these 20 years a more gradual, and also significantly larger, appreciation than is indicated by its rate against the U.S. dollar. Canada and Japan show particularly small divergences from numeraire rates, as would be expected from the large weight in their case of the United States. The divergences between movements in effective rates and in dollar rates for other currencies have tended to balance out over time, but they have been significant at particular moments of time, and sometimes for periods as long as 2 years. These divergences have stemmed from changes in other countries’ parities and not merely in their market rates around given parities. Interpretation of the statistical findings is therefore best focused on particular periods of significant divergence between numeraire and effective rates. This may be prefaced by a brief discussion of the relation between (numeraire) market rates and parity rates, on the one hand, and the relation of both to the respective effective rate.

Chart 1.

Movements of Dollar Exchange Rates, Compared with Movements of Effective Market Exchange Rates, 1949–69 1

(January 1959 = 100)

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1 Average monthly market exchange rates are derived from Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, and Supplement to Banking and Monetary Statistics, Section 15, International Finance (Washington, 1962).* Free market rate.

Consider first a hypothetical situation in which par values were absent or inoperative and market exchange rates fluctuated freely in response to market forces. In this situation, changes in effective exchange rates caused by changes in the numeraire rate of another currency could be offset immediately, to the extent that they caused a market disequilibrium for the given currency, by compensating changes in its own numeraire exchange rate. The latter rate could therefore be expected to respond relatively speedily and smoothly to changes in the effective rate, unless such changes were compensated in other ways, such as relative movements in domestic prices.

This freedom of response may clearly be restricted by the existence of limits of permissible fluctuation around par values, such as the maximum of 1 per cent on either side of parity against the numeraire currency permitted by the Fund’s Articles of Agreement and the slightly smaller margins currently prevailing. In practice, as described below, movements within even this relatively narrow band have on a number of occasions offset, or largely offset, the indirect impact on effective parity rates of changes in the parities of other currencies. It must be recalled that the impact of such parity changes is always diluted in greater or lesser degree by the weight of the countries whose parities have not changed. By the same token, the indirect impact of changes in dollar rates of other currencies within existing bands (i.e., without parity changes) can normally be offset by within-band movements of the given currency.

The extent to which the influence of exchange adjustments of currencies can be offset by a within-band movement in the market rate of the given currency against the dollar, exerting a stabilizing influence on its effective market rate, will depend at any time on (1) the size of the exchange adjustment in other currencies, (2) the closeness of trading relationships, determining the weight of these changes in the effective exchange rate of the given currency, and (3) the current position of the market exchange rate of the given currency within its existing band, delimiting the remaining scope for movement in the relevant direction. Because of the limitations imposed by this last factor, a further constraint is likely to be imposed by (4) the frequency of par value changes of other currencies in the same direction: even if such changes are small, they will tend to “use up” the scope for compensating changes in the market dollar rate of a given currency around its existing par value. It follows from these considerations that if par value changes generally should become larger, more frequent, or less divergent in direction the indirect impact of any particular par value change on the effective exchange rates of other currencies would tend to become more noticeable over time, and less easy to absorb without consequential par value changes on the basis of current exchange rate margins.

The way in which the indirect impact of other parity changes may be absorbed in market fluctuations was illustrated by the impact of the revaluation of the deutsche mark on October 26, 1969. Table 2A compares the impact of the 9.3 per cent revaluation on the effective parity rates of other currencies, on the one hand, with the change in effective market rates, on the other hand (the latter based on the monthly average of the relevant market rates against the dollar in November 1969, compared with the monthly average of September 1969). The changes in effective parity rates for countries other than Germany ranged from an effective depreciation of 4.4 per cent for Austria to one of 0.2 per cent for Canada. For each of the currencies other than the deutsche mark and the U.S. dollar, the effective market rate depreciated by less than the effective parity, or by the same amount, indicating a “stabilizing” movement (appreciation) in the market rates of these currencies against the U.S. dollar. This market movement mitigated the devaluation effect on these currencies, other than the dollar, but tended to exacerbate the effective depreciation of the U.S. dollar.9 The scope for this appreciation in market rates of these currencies had been created in part by the opposite pressures that had been exerted in earlier weeks and months by the devaluation of the French franc (reflected in Tables 2B and 2C) and, more generally, by speculative pressures based on anticipation of a possible revaluation of the deutsche mark. The two par value changes, in divergent directions, provided an offsetting influence on effective exchange rates of other currencies.

Table 2A.

Effective Exchange Rates: Impact of Revaluation

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Sources: International Monetary Fund, International Financial Statistics; Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, and Supplement to Banking and Monetary Statistics, Section 15, International Finance (Washington, 1962); Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

Based on change in the average market rate from the month preceding the parity adjustment to the month following the adjustment.

Table 2B.

Effective Exchange Rates: Impact of Devaluation

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Sources: International Monetary Fund, International Financial Statistics; Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, and Supplement to Banking and Monetary Statistics, Section 15, International Finance (Washington, 1962); Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

Based on change in the average market rate from the month preceding the parity adjustment to the month following the adjustment.

Table 2C.

Percentage Changes in Market Rates on U.S. Dollar and in Effective Market Rates in Selected Periods

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Sources: International Monetary Fund, International Financial Statistics; Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, and Supplement to Banking and Monetary Statistics, Section 15, International Finance (Washington, 1962); Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

By contrast, the period from the eve of the U.K. devaluation in 1967 to the aftermath of the French devaluation in August 1969, with two downward parity changes and no upward change, showed no such equilibrating tendencies. This resulted in substantial movements in effective exchange rates of currencies whose parities were not changed (Table 2C and Chart 2). The equilibrating tendencies at the time of the recent revaluation of the deutsche mark may also be contrasted with the impact of the 1961 revaluation (Chart 3). Movements in market rates of other currencies were then predominantly downward, exacerbating the indirect influence on effective parity rates (Table 2A); this reflected the continuation of speculation against currencies in relatively weak positions, based in part on doubts whether the adjustment in the parity of the deutsche mark itself was definitive. Similar influences limited the stabilizing movement in market rates after the November 1967 devaluation of sterling (Table 2B).

Chart 2.

Comparative Movements in the Effective Parity Rate, the Effective Market Exchange Rate, and the Dollar Exchange Rate, 1967–69

(January 1959=100)

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Chart 3.

Comparative Movements in the Effective Parity Rate, the Effective Market Exchange Rate, and the Dollar Exchange Rate, 1961

(January 1959 = 100)

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Over a span of years, given the limited scope for movements in market rates in relation to parity, the indirect influence on effective exchange rates may be assessed most conveniently in terms of effective parity rates, rather than effective market rates. The former comparison also avoids incidence of temporary influences on market rates. Table 3 shows effective parity changes of the 14 countries during each year from 1959 through 1969, with the countries arranged according to whether their own par values were reduced, increased, or maintained in this period. The last two lines of the table compare any such changes in the country’s own par value with the movement in its effective par value.

Table 3.

Changes in Effective Parities, 1959–69 1

(Effective depreciation (—) or appreciation (+); in per cent)

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Sources: See Table 1 and International Monetary Fund, International Financial Statistics.

Note: The monthly spot rate was taken for Canada prior to resumption of par value obligations in May 1962.

Countries are arranged in three groups beginning with countries whose dollar parities were decreased during the period, followed by those whose dollar parities increased and then by those whose dollar parities did not change.

January to December.

End of December to end of December for 1960–69.

Perhaps the most striking feature of the table is the range of movement shown in effective parities of the countries that maintained their par values unchanged—from an effective appreciation of 4.7 per cent for the United States to a depreciation of 5.3 per cent for Austria over the 11-year period. These differences are due almost entirely to the differences in geographical trade patterns. This is perhaps most clearly illustrated for the year 1961, in which there were a 5 per cent increase in the parities of the deutsche mark and the Netherlands guilder and a devaluation of about the same amount in the Canadian dollar.10 The net effect of these three changes, inter alia, was a depreciation in Austria’s effective parity by 2.7 per cent but an appreciation in the effective parity of the U.S. dollar by 1.1 per cent. The explanation is that in 1961, on the basis of the 1959 trade matrix, Canada had a weight of 1 per cent for Austria and 39 per cent for the United States; Germany and the Netherlands combined had a weight of 56 per cent for Austria and 14 per cent for the United States. Table 4 illustrates the influence of the differing weights of the revaluing countries as a group, and of the devaluing countries as a group, on the divergent movements in the effective exchange rates of the other countries. The large weight of Canada in the effective exchange rate of the United States was responsible for an opposite pull in the early 1950’s, toward an effective depreciation for the United States (Chart 1). This reflected the sharp appreciation of the Canadian dollar following the adoption of a fluctuating rate; the impact on the effective rate of the U.S. dollar went far to offset the earlier appreciation effect of the 1949 European devaluations.

Table 4.

Effective Exchange Rates: The Influence of Trade Weights

(In per cent)

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Sources: See Table 1; International Monetary Fund, International Financial Statistics; Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues.

Based on the average of the 1959 and 1967 trade shares in manufactured exports among 14 industrial countries.

France, United Kingdom, Canada, Denmark.

Germany, Netherlands.

United States, Japan, Norway, Sweden, Italy, Belgium, Switzerland, Austria.

These comparisons suggest that the effective appreciation of the U.S. dollar in the period since European currencies attained convertibility (an effective appreciation of 4.7 per cent)11 did not result from any general devaluation bias in the adjustment of par values. Judged by the impact of competitors’ par value changes on industrial countries generally, there has been no such general devaluation bias.12 The effective appreciation for the United States since 1959 reflects rather the particular orientation of its trade, and particularly its large trade with Canada.

The divergence in the indicated movement of effective exchange rates of currencies whose own numeraire rates had not changed would be considerably reduced if the weights were to be calculated on the more general basis of, for example, the share of each country in global exports of manufactures by industrial countries as a whole, with no regard for geographical trade patterns. Application of such weights, based on the 1967 trade pattern, would produce for the United States an appreciation in the effective parity of 0.5 per cent in the same period, and a slightly smaller appreciation (0.4 per cent) for the other currencies whose parities had not changed.13 Ten of the 14 countries would then show a devaluation bias among their partner countries, for amounts of about ½ of 1 per cent; the 4 devaluing countries—the United Kingdom, France, Canada, and Denmark—would show a slight revaluation bias, of other countries, of up to 1.2 per cent.14

The indices of effective exchange rates presented in this paper can be taken only as general indications. A number of variations and refinements might be made in the system of weighting, e.g., to allow for particular repercussions in third markets, or conceivably to reflect differences in estimated elasticities of demand for exports and for imports, or differences in demand and supply elasticities among different countries. The absence of such refinements must be borne in mind in interpreting the present results. It should be emphasized that with the simpler approach used above the effects on trade of a given movement in the effective exchange rate will vary according to the source of the change. If, for example, a 2 per cent depreciation in country A results from a 10 per cent appreciation in a single competitor country (B) rather than from a 2 per cent depreciation in A’s numeraire rate, then the effect of the change on A’s trade balance would tend to be greater if the elasticity of demand for A’s exports over the relevant price ranges is higher in B, the revaluing country, than in the industrial countries as a whole, and if A’s elasticity of demand for imports from B vis-à-vis domestic products is higher than for imports from the industrial countries as a whole.15

IV. Significance of the Effective Exchange Rate

What significance should be attached to indirect influence on the effective exchange rate, i.e., to such movements in the effective rate as differ from movements in the numeraire rate? The question may be approached by noting, first, a number of ways in which indirect influences do not exert the same force as the indicated equivalent in a direct rate change, on the basis measured in this paper.

(1) The impact of the indirect influences will usually be more narrowly spread geographically, changing the terms of competition of the given country with one or two countries, rather than being spread across the board by a change in the given country’s own numeraire rate. This will make the effects on trade sensitive to any differences in price elasticities vis-à-vis various competing countries, as indicated above.

(2) Similar differences may be entailed for the responsiveness of export supplies to exchange rate adjustment by a competing country, against the “equivalent” smaller adjustment in the given country’s own numeraire rate. The operative influences here will be the comparative size of supply elasticities in the countries concerned and the size of these elasticities at different ranges of exchange adjustment. This will depend, inter alia, on the response of domestic financial policies to the effective exchange adjustment. The interrelationships here are complex, and no general tendency is apparent. For the given country, an indirect depreciation will tend to have less net positive effect on the trade balance (involve smaller supply elasticities) the less likely the appreciating country is to increase domestic demand in line with its appreciation, and the less likely the given country is to decrease domestic demand in line with its (much smaller) effective depreciation. The depreciating country may reasonably be considered more likely to take disinflationary measures alongside a visible depreciation of the same magnitude in its numeraire rate; but the total impact of a direct depreciation will also depend on an expansion in domestic demand in other countries in line with the (in this case very small) relative appreciations in their effective rates.

(3) Indirect influences on effective exchange rates will not have the same impact on capital movements as movements in the numeraire rate. It may be recalled that the weights used in this paper take no account of capital movements. The indirect influences may at times exert a significant impact on capital flows—e.g., in the revaluation of another currency that previously had acted as a magnet, drawing speculative funds from the given currency. In other situations, by contrast, a change in the effective exchange rate may appear to foreshadow a corrective change in the numeraire rate and thereby itself induce speculative flows.

Assessment

The movement in a country’s effective exchange rate or total exchange relationship is an analytical concept subject to varying definitions according to the analytical purpose involved. The definition adopted in this paper is focused on trade competitiveness among industrial countries, although it is not, of course, by itself a measure of competitiveness.

On this basis, movements in effective exchange rates do not generally show significant divergences from movements in numeraire exchange rates over time, although they provide a special indicator for the relative value of the U.S. dollar. However, at particular times, usually associated with changes in parities but extending for periods of up to two years, changes in effective rates since 1959 have diverged from numeraire rates typically by 2 per cent and up to a maximum of slightly over 4 per cent. Movements of this magnitude have been sufficiently large to have significant impact on domestic economic stability. In some cases (e.g., in Austria following the German revaluation in 1969) these influences have prompted domestic measures designed to offset at least a part of the indirect exchange adjustment.

The impact of indirect exchange adjustments is likely to be particularly significant for countries with close trading relationships with larger countries, other than the numeraire currency country; this influence will exist whether or not the rate adjustment of the partner country is followed. Thus the Netherlands, which followed Germany in its 5 per cent revaluation in 1961, then effected a revaluation in its effective parity of only 3.3 per cent, while in 1969 it experienced an effective parity depreciation of 3.0 per cent through leaving its parity unchanged alongside the German revaluation of 9.3 per cent. If changes in parities were expected to become more frequent, divergences of this kind would be expected to grow. There would also tend to be less scope for the impact of such divergences to be partially absorbed by changes in market rates around existing parities, on the basis of existing margins.

The question remains of what significance is to be attached to a divergence in an effective exchange rate over the movement of the numeraire rate that persists over time. The persistence of such a situation may itself indicate that the economy has adjusted to the initial divergence, which had thereby lost its original significance for international competitiveness. This line of reasoning is, however, equally valid for the long-term significance, or lack of it, of any exchange rate movement. In the long term, that is, exchange rates and other influences on international competitiveness adjust to each other: the smaller the adjustment by way of the exchange rate, the greater the adjustment that will be forced onto other instruments and sectors of the economy, and vice versa. The relevant exchange rate adjustment will be the change in the effective exchange rate, rather than in the numeraire exchange rate; and failure to observe the distinction may result in analytical misjudgments. Thus, a country may decline to follow an appreciation in the currency of an important trading partner and thereby experience an effective depreciation. It may subsequently absorb that depreciation by experiencing a differentially high rate of inflation. If this differential rate of inflation were then compared with the stability in the country’s numeraire rate, a loss in competitiveness compared with the period preceding the indirect exchange adjustment might be inferred, in a way that would be avoided by reference to the effective exchange rate. Of course, a more comprehensive indicator of competitiveness would be provided by comparative movements of prices in terms of an international unit, such as the U.S. dollar. The effective exchange rate does not measure competitiveness; it does give a closer approximation to the influence of the exchange rate on competitiveness than is provided by the nominal exchange rate.

APPENDICES

I. Construction of the Index

The construction of the effective exchange rate index involves three separate steps: (1) the computation of weights; (2) the computation of percentage changes in exchange rates: 16 (a) market exchange rates, from January 1949 to December 1969; (b) parity rates, from January 1959 to December 1969; and (3) the weighting of exchange rates. The weights are computed from the sum of exports of manufactures.17 Each country’s weight represents its share of manufactured exports to and imports from any one of the 13 other countries against its total trade in manufactures with all 13 countries.

W=(Xij+Xji)Σ(Xij+Xji)

Data on imports are derived from export data; thus, Belgium’s exports to France are taken to constitute France’s imports from Belgium, while France’s exports to Belgium are taken as Belgium’s imports from France. The sum of Belgium’s exports to and imports from France as a percentage of Belgium’s exports to and imports from all 13 other countries represents Belgium’s trade weight in relation to France.

The weights are then applied to the percentage changes in the exchange rates of the 14 countries. The difference between the percentage change in the exchange rate of, say, country A and the sum of the 13 other countries’ percentage changes in their exchange rates, each change weighted by its proportionate trade weight with country A, nets the percentage change in country A’s effective exchange rate. The formula, as indicated in footnote 3, is

E1=N1 - (w2N2+w3N3+ … +wnNn),

where E is the effective percentage change, N is the actual percentage change, and w is the weight. These percentage changes in effective exchange rates are then computed as index numbers in the form of a chain index, with the base period January 1959 equaling 100.

In order to allow in the index numbers for shifts in the trade patterns over time, weights have been computed for the years 1951, 1959, and 1967. They are incorporated in the index by linking, in June 1955, the 1949–55 portion of the index (weighted with 1951 trade shares) with the 1955–63 portion of the index (based on 1959 weights) and, in June 1963, linking on the 1963–69 portion of the index (based on 1967 weights). The splicing points at mid-1955 and mid-1963 have been smoothed out by a simple arithmetic manipulation: the midsection of the index, 1955 to 1963, is multiplied by a quotient derived from the ratio of the index number in June 1955 at 1951 weights and the same index number at 1959 weights. A similar quotient is then calculated for the second splicing point in June 1963.

The same principle has been followed for the calculation of the effective parity rate index. Starting in January 1959, this index is spliced in June 1963, so as to reflect the 1959 trade pattern from 1959 to mid-1963 and the 1967 pattern from mid-1963 to the end of 1969.

II. Effect of the 1949 Devaluations

In the calculations published in International Financial Statistics (January 1968) of the effective depreciation or appreciation of parities at the time of the devaluations in September 1949 and November 1967, four different systems of weighting were applied using trade data for the year ended September 1949. These related the parity change of the given country to (1) parity changes of all other countries, weighted by their shares in total world exports; (2) parity changes of industrial countries, weighted by their shares in total exports of industrial countries; (3) parity changes of all other countries, weighted by the share of each country in the total exports of the given country (i.e., by their size in the latter’s export market); and (4) parity changes of all other countries, weighted by relative shares in the imports of the given country (i.e., by their relative size as suppliers to the given country). The last two bases of comparison showed a marked divergence from the first two bases (see Table 5). The effective depreciation shown under basis (3) is in each case the smallest of the four bases. This reflects the strong impact of the parallel devaluations of nonindustrial countries, an impact that is excluded entirely in basis (2), and in the basis used in this paper, and that is diluted considerably in basis (1), because the share of nonindustrial countries in world exports is smaller than their share in the export markets of individual industrial countries.

Table 5.

Impact of Different Weights on Calculations of Effective Depreciations and Appreciations

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Source: See Table 1.

International Financial Statistics, January 1968, p. 352.

Weights reflecting the bilateral trade relationships described in this paper, applied to trade data for 1951 (the necessary data on exports of manufactures is not available for earlier years).

Based on comparison of average of old official rate and free market rate with new free market rate.

The differences between the various weighting systems are highlighted by the unique size and extent of parity changes in September 1949. The divergences are notably smaller when the various systems are applied to the 1967 devaluations, as shown in the second half of Table 5.

Table 6.

Trade Matrix, 1951 1

(Change of 1 per cent (+ or —) in dollar exchange rate of country in stub denotes change of indicated fraction of 1 per cent (— or +) in effective exchange rate of country in heading)

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Source: Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

Showing the proportion of trade in manufactures (exports plus imports) of country in heading with country in stub, in relation to former country’s trade in manufactures with 13 countries combined. The proportion is expressed so as to sum to 1 per cent; if the decimal points are dropped, the figures may be read as percentages.

Table 7.

Trade Matrix, 1959 1

(Change of 1 per cent (+ or —) in dollar exchange rate of country in stub denotes change of indicated fraction of 1 per cent (— or +) in effective exchange rate of country in heading)

article image
Source: Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.

Showing the proportion of trade in manufactures (exports plus imports) of country in heading with country in stub, in relation to former country’s trade in manufactures with 13 countries combined. The proportion is expressed so as to sum to 1 per cent; if the decimal points are dropped, the figures may be read as percentages.

Un indicateur des taux de change effectifs

Résumé

Le taux de change de la monnaie d’un pays est généralement exprimé en termes d’une seule autre monnaie dite monnaie numéraire; cependant, dans la pratique, un pays est lié par un réseau de taux de change à diverses autres monnaies et sa position compétitive est affectée lorsque d’autres pays modifient le taux de leur monnaie par rapport à la monnaie numéraire. Cette étude fournit une formule de mesure statistique des modifications des taux de change effectifs des monnaies de 14 pays industriels au cours d’une période récente ininterrompue 1949–69, en insistant plus particulièrement sur les onze dernières années. Cette formule tient compte de l’influence indirecte des modifications de taux, par rapport au dollar E.U., des monnaies de pays tiers et permet ainsi de calculer les variations du taux de change de chaque pays par rapport à l’ensemble des autres monnaies. Les coefficients de pondération utilisés pour déduire l’influence indirecte sur le taux de change effectif d’une monnaie donnée sont conçus de façon à refléter la compétitivité commerciale entre les pays industriels; ils sont basés sur l’importance proportionnelle du pays modifiant le taux de sa monnaie dans les échanges de produits manufacturés du pays donné avec l’ensemble des autres pays industriels.

Les résultats statistiques montrent que les divergences entre les taux de change effectifs et les taux de change nominaux n’ont été importantes que pendant les périodes de modifications de parités; ces modifications ont entraîné des mouvements d’un seul palier des taux de change effectifs des autres pays qui ont pu atteindre plus de 4 pour cent. L’analyse met en relief les perturbations que peut entraîner, pour la position compétitive d’un pays, des modifications de parité dans le même sens d’autres pays. Cependant, depuis 1959, les modifications de taux par rapport au dollar E.U. effectuées par les pays industriels ont été plus ou moins équilibrées entre dévaluations et réévaluations sur une base pondérée. Il n’était possible de déceler aucun biais général de dévaluation dans les ajustements de parité des 13 monnaies autres que le dollar E.U. Par ailleurs, à cause du rôle particulièrement important que joue le Canada dans les échanges des Etats-Unis, qui a accru l’effet de réévaluation pour les Etats-Unis de la dévaluation canadienne de 1962, le taux de change effectif du dollar E.U. accuse une augmentation nette de 4,7 pour cent pour la période 1959–69. En revanche, parmi les pays qui n’ont pas modifié leur parité, l’Autriche, pour laquelle les réévaluations de l’Allemagne ont eu une importance particulièrement grande, a subi une dépréciation effective de sa monnaie de 5,3 pour cent au cours de la même période.

Un indicador de los tipos de cambio efectivos

Resumen

En general, el tipo de cambio de la moneda de un país se expresa en relación con una determinada moneda, que sirve de denominador; pero en la práctica, el país mantiene una red de tipos de cambio frente a otras diferentes monedas, y su posición competitiva se ve afectada cuando los otros países modifican sus tipos de cambio frente a la moneda que sirve de denominador. En este estudio se presenta una medición estadística de las variaciones que experimentaron los tipos de cambio efectivos de las monedas de 14 países industriales durante el reciente período de 1949 a 1969, prestándose atención especial al período comprendido a partir de 1959. Este concepto tiene en cuenta los efectos indirectos que ejercen las modificaciones de los tipos fijados en relación con el dólar de EE.UU. que efectúan terceros países y, por lo tanto, ofrece una medición de las variaciones del tipo de cambio de cada país frente a las demás monedas en conjunto. Los factores de ponderación que se han utilizado para derivar la influencia indirecta ejercida sobre el tipo de cambio efectivo de una moneda dada tienen por objeto determinar la posición competitiva comercial entre los países industriales; dichas ponderaciones se basan en la importancia relativa que el país que modifica el tipo tenga en el comercio de manufacturas del país en cuestión con otros países industriales en conjunto.

Los resultados estadísticos demuestran que las divergencias entre los tipos de cambio efectivos y los tipos de cambio nominales fueron considerables únicamente durante los períodos de modificación de la paridad; esas variaciones causaron cada vez movimientos en los tipos de cambio efectivos de otros países, de hasta un máximo de más de 4 por ciento. En el análisis se ponen de relieve las posibles perturbaciones que pueden producirse en la posición competitiva de un país a causa de las modificaciones de la paridad efectuadas por otros países en un sentido uniforme. No obstante, desde 1959, y calculadas por el método de ponderación, las modificaciones de los tipos frente al dólar de EE.UU. efectuadas por los países industriales han estado bastante equiparadas entre las devaluaciones y las revaluaciones. No pudo descubrirse ninguna tendencia general de devaluación en los ajustes de la paridad de las 13 monedas distintas del dólar de EE.UU. Al mismo tiempo, debido a la participación particularmente elevada del Canadá en el comercio de Estados Unidos, que hace que se acentúe el efecto revaluador para este país de la devaluación del Canadá realizada en 1962, el tipo de cambio efectivo de Estados Unidos muestra una valorización neta del 4,7 por ciento en el período de 1959–69. En contraste, entre otros países que no modificaron sus paridades, Austria, país en que las revaluaciones alemanas tuvieron una repercusión particularmente fuerte, experimentó una desvalorización efectiva del 5,3 por ciento durante este período.

*

Mr. Hirsch, Senior Advisor in the Research Department, is a graduate of the London School of Economics. He was formerly Financial Editor of The Economist, and on the editorial staff of The Banker. He is the author of Money International (London, 1967) and other writings on financial subjects.

Mrs. Higgins, a graduate of the George Washington University, was a research assistant in the Research Department of the Fund when this paper was prepared. She has now joined the International Finance Division of the Federal Reserve Board.

1

“Results of the Devaluations of September and October 1949,” Vol. III, No. 1 (1950), pp. 8–9, and “A Comparison of the Devaluations of 1949 and 1967,” Vol. XXI, No. 1 (1968), pp. ii-iii and 352, International Monetary Fund, International Financial Statistics. See also pages 480–82 below.

2

Since the parity of a currency is always expressed in terms of the numeraire, the term “parity” will continue to be used in this paper in the analytical meaning of “numeraire parity.” Where changes in the parity are expressed in relation to a composite of other parities, this will be referred to as changes in the “effective parity.” The term “exchange rate” is used in this paper in the generic sense, covering, e.g., both a parity rate and a market exchange rate.

3

In a world of n currencies (1, 2, …, n), in which currency n is the common numeraire, and where E is the percentage change in the effective exchange rate, N the percentage change in the numeraire rate, and w1wn represent the relevant weights, which sum to unity,

E1 = N1 - (w2N2 + w3N3 + … + wnNn).

The formula is an approximation; the precise relationship is given by the ratio of changes in the numeraire rate of the given currency to the sum of weighted changes in numeraire rates of other currencies. The formula used here would therefore be unsuitable for calculation of changes in effective exchange rates where changes in numeraire rates were very large. For changes of the size experienced by industrial countries in the recent period, the difference between the two formulas is hardly significant. Thus, applied to the 1967 devaluations, the largest difference shown was between an appreciation in the effective exchange rate of Italy by 1.22 per cent (Table 2B) and an appreciation of 1.18 per cent, which would have been shown if the “ratio” formula were used.

4

In the total relationship of the given currency with all other currencies.

5

I.e., excluding trade of the Soviet Union, mainland China, and other non-reporting communist countries.

6

I.e., counting as one the currency of a common currency area with a common external exchange rate and no fluctuations in rates within the currency area.

7

Peter B. Kenen, “The International Position of the Dollar in a Changing World,” International Organization, Vol. XXIII (Summer 1969), p. 710. The countries in the grouping were Canada, Japan, Australia, India, United Kingdom, France, Germany, Netherlands, Belgium, Italy, Spain, Brazil, Mexico, and Venezuela.

8

This is in line with the approach developed by Paul S. Armington (“The Geographic Pattern of Trade and the Effects of Price Changes,” Staff Papers, Vol. XVI (1969), pp. 179–201) but, for purposes of simplicity, is limited to reflecting the bilateral trade relationships. Full application of the Armington approach would reflect the impact of such relationships also in third markets. Preliminary calculations suggest that the effect of such an emendation might not be great; whereas the difference between the present, bilateral approach and the aggregative approach of reflecting the relative size of each country in world trade or group trade, with no account of trade pattern, is considerable. (See also pp. 474–75 and 482.)

9

The depreciation of the market rate of the deutsche mark itself in terms of its dollar parity was, however, an equal force in the opposite direction, so that the depreciation in the effective market rate of the dollar was the same as the depreciation in its effective parity rate (Table 2A).

10

It may be recalled that the market exchange rate of the Canadian dollar is used in lieu of the parity, prior to Canada’s resumption of par value obligations in May 1962.

11

The appreciation in the effective market rate was also 4.7 per cent.

12

This can be seen in the last two lines of Table 3. A devaluation bias is present if there is a positive difference between the change in a country’s effective parity and any parity change of its own. This was so, from 1959 through 1969, in significant amounts for the United States, Germany, and Canada, and for amounts of less than 1 per cent for the United Kingdom, Japan, Sweden, and Norway. For the other seven countries there was a revaluation bias by this test.

13

The remaining difference reflects the relatively large share of the United States as an exporter of manufactures; for countries other than the United States, this gives a larger weight to the (other) countries with no parity change, thereby slightly diminishing the small effective appreciation.

14

The effective appreciation of the U.S. dollar in this period, on either basis of weighting, falls well short of the apparent relative appreciation in its internal value, if the latter is measured by the comparative increase in the consumer price index in the United States against the weighted increase in the other industrial countries. In the 11 years to the end of 1969, the consumer price indices of the 13 other countries, weighted according to the vertical column for the United States in the 1967 trade matrix (Table 1), rose by 45 per cent, against the U.S. increase of 34 per cent, indicating excess inflation outside the United States of 11 per cent. If the composite index is recomputed to omit Japan, whose increase of 75 per cent in consumer prices in this period plainly reflects structural changes in the economy rather than any loss in competitiveness, the excess inflation outside the United States is reduced to 4½ per cent—broadly matching the dollar’s effective exchange appreciation on the basic weighting system used in this paper. Even in the period from the end of 1965 to the end of 1969, consumer inflation outside the United States showed a positive differential of 2 per cent, or 0.5 per cent excluding Japan. For this 4-year period, the effective appreciation of the U.S. dollar parity was 1.1 per cent on the basis of the 1967 trade matrix, so that for this period, unlike the longer period, an effective appreciation (of 0.6 per cent) in purchasing-power parity would be shown if Japan is excluded from the comparison.

15

In addition, the elasticity of demand may vary according to the size of adjustment. Thus, if price elasticities are uniform in all countries for any particular exchange adjustment but are an increasing function of the size of the exchange adjustment, then the proportionate effects of the 10 per cent appreciation by one country will exceed the effects on the given country of a 2 per cent depreciation in its own numeraire. An exchange adjustment against one country alone will also tend to cause particular switches in trade between foreign suppliers and markets.

16

Expressed in U.S. dollars per unit of national currency and based on daily New York market buying rates, as certified by the Federal Reserve Bank of New York. Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues, and Supplement to Banking and Monetary Statistics, Section 15, International Finance (Washington, 1962); International Monetary Fund, International Financial Statistics.

17

Export data refer to Standard International Trade Classification, Sections 5 through 8. Source: Organization for Economic Cooperation and Development, Foreign Trade, Series B: Commodity Trade—Analysis by Main Regions.