“Real” Effective Exchange Rate Indices: A Re-Examination of the Major Conceptual and Methodological Issues

Edouard Maciejewski

doi:10.5089/9781451972740.024.A002

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“Real” Effective Exchange Rate Indices: A Re-Examination of the Major Conceptual and Methodological Issues

Author: Mr. Edouard Maciejewski

Publication Date:: 01 Jan 1983

eISBN:: 9781451972740

Language:: English

Keywords:: SP; cover book; bibliography; activities of the International Monetary Fund; import substitute; relative price; price competitiveness; exchange rate movement; quantity decomposition; Exchange rates; Imports; Exchange rate adjustments; Nominal effective exchange rate

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Various “real” effective exchange rate indices, that is, nominal effective exchange rate indices deflated by indicators of relative prices, have been developed and used since the mid-1970s. On several occasions, such indices have been used as measures of the “real” appreciation or depreciation of a given currency and “real” indices have often been regarded as appropriate indicators of equilibrium exchange rates or, more generally, of international competitiveness. Specifically, the calculated “average” movements have sometimes been used as direct measures of “average” deviations from assumed equilibrium exchange rates, and, on occasion, it has been tempting to recommend an exchange rate adjustment on such a basis only. There is considerable doubt, however, that such a use of these real indices is appropriate. Moreover, even though the concept of international competitiveness was not defined sufficiently, real effective exchange rate indices have been used to determine how loss in international competitiveness could be made up. Also, as suggested by past and recent experience with the calculation of real indices, the calculated values may result in wide quantitative differences, owing to a number of methodological and data problems. Although these problems have been raised and sometimes discussed extensively in the available literature and in some case studies, there has been relatively less discussion of the informational content and appropriate use of most of the available real indices and alternative indicators.1

Abstract

This study reviews the major conceptual and methodological problems that are involved in the use of available real indices. Its main purpose is to investigate the informational content of different indices and their interpretation in relation to selected analytical or policy questions and different sets of market conditions. This study shows that the informational content of the standard real index (defined as the nominal index deflated by relative price movements) is a misnomer, since it is a nonexchange rate concept. By definition, the exchange rate is an inherently nominal measure, that is, the relative price of two currencies. However, as shown in Appendix I, the same index is mathematically equivalent to an index of relative prices adjusted for nominal effective exchange rate movements.² By definition, this latter index is one of relative prices expressed in a common currency,³ whose interpretation is less subject to controversial conclusions with respect to exchange rate evaluation.

On this basis, the study shows that an economically meaningful interpretation of both standard real indices and adjusted relative price (cost) indices is likely to depend heavily on the combination of four elements. These are (1) the proper choice of the base period for the index in connection with a systematic analysis of underlying balance of payments developments; (2) the proper choice of the weighting procedure used in the index in relation to the analytical or policy question addressed and to the specific set of market conditions under consideration; (3) the plausibility of the relative price (cost) indicator used in the selected index in relation to a specified analytical or policy question addressed; and (4) the mathematical formulation of the index.

This study concludes that there are as many adjusted relative price (cost) indices as there are analytical or policy questions addressed and related different sets of market conditions and that each index can fulfill only a limited number of purposes. In this respect, the study shows the inherent limitations of any of the calculated indices for the purpose of judging the adequacy of a given exchange rate. At the same time, however, the study emphasizes that such calculated indices may provide useful signals about underlying price competitiveness and cost developments, notably through their impact on profitability. Such signals are expected, in turn, to suggest the need for specific policy actions to contain or to reverse any unfavorable trends in international competitiveness. However, since the calculations can provide only a rough measure of the direction of change, any apparent changes in international competitiveness should also be assessed in conjunction with a forward-looking analysis of underlying balance of payments developments, especially in the current account. In no case should the results obtained by any of the available adjusted relative price (cost) indices be elevated into firm norms and used as the only indicators of currency overvaluation or undervaluation. For a number of reasons (e.g., the degree of approximation involved in the choice of the index, the shortcomings inherent in available price (cost) statistics), the calculated values should always be interpreted with caution.

The study starts with a brief review of the evolution of the concept of the effective exchange rate from the nominal to the standard real indices, pointing out the interpretative and methodological limitations of most of the standard exchange rate indices used in intercountry comparisons. The following section reviews the theoretical basis for the calculation and interpretation of most of the available real indices, including a brief discussion of the links between relative price (cost) indices, the balance of payments, and exchange rate in equilibrium; this discussion helps to sort out the implications for the choice of a relevant base period. The study then discusses the importance of specific market conditions for the choice of relevant weighting procedures and the need for a clear definition of what the price (cost) indicator of the index is intended to measure in relation to a selected policy objective or analytical question and the type of products and price formation process involved. Against this background, the study provides some general guidelines for the appropriate use of available relative price (cost) indices. Appendix I discusses specific weighting procedures and the impact of different mathematical formulations on the calculated values and their interpretation; it includes a summarized derivation of nominal and real effective exchange rates and of relative price (cost) indices adjusted for exchange rate movements. Appendix II suggests a practical guide to the use of available adjusted relative price (cost) indices (and alternative indicators) and includes an extensive discussion of their specific features.

I. Effective Exchange Rate Indices

Nominal Effective Exchange Rate Indices

The notion of the nominal effective exchange rate was initially developed by Hirsch and Higgins (1970) with the concept of nominal (weighted) effective exchange rate for a given currency. The latter was assumed to represent the total (evolving) relationship between the actual value of the currency expressed in terms of a numeraire and the aggregate value of a relevant composite of currencies expressed in terms of the same numeraire. As such, the index was deemed to “illustrate one particular influence—that emanating from exchange rate changes—on international competitiveness” (Hirsch and Higgins (1970), p. 458). The latter concept and its measurement were subsequently spelled out by Artus and Rhomberg (1973), Thakur (1975), and Rhomberg (1976). In particular, they stressed the necessity for a link to be established between the policy question that the index is expected to answer and the weighting system to be appropriately used in the index. In this respect, Rhomberg (1976, p. 88) pointed out that even if the economic meaning of the selected indices is sufficiently clear, the calculated values could differ with regard to the base period used, the partner countries (or competitors) included, the calculation of proportionate changes in exchange rates, the weights used in averaging these changes, and the type of averaging formula employed.

As shown in Appendix I, Derivation of nominal effective exchange rate index, the basic form of any such index is defined and has to be interpreted as showing the changing nominal value of a specific fixed basket of currencies over time, owing to nominal exchange rate movements. As such, the index can provide an answer to only one question—What are the effects of exchange rate movements relative to the value of a selected basket of currencies in a given base period? This is due simply to the fixed weighting procedure embodied in the construction of the index, which makes any standard nominal index nothing but a simple Laspeyres exchange rate index. Since the latter is defined as a constant quality and constant quantity of items, it can only show the change over time of the constellation of the exchange rates involved (for the same items and outlets) relative to a specific base period. In the particular instance used in the derivation, the index provides an unambiguous indication as to how the value of the selected country’s earnings (in local currency) from commodity exports for the current period compares with the value of its earnings for a base period as a result of the cumulative effects of exchange rate movements. This index is not directly a measure of international competitiveness in the selected country’s exporting sector, and it does not measure the appropriate level of the exchange rate for that country’s currency.

Also, as suggested by the derivation, the interpretation of the index depends directly on the proper choice of the weights employed in the index; in turn, these weights depend “on the particular policy objective selected as the focal point of the index” (Rhomberg (1976, p. 89)). In other words, as suggested by Rhomberg, it is necessary to lay down rather precisely what the index is intended to measure in the particular application considered and then to choose the relevant weights. If, as is done in the derivation provided in Appendix I, the focal point of the index is the study of the effects of exchange rate movements on a particular country’s earnings from commodity exports, a bilateral export-weighted index of the nominal effective exchange rate would be appropriate. If the focal point is the study of the effects of exchange rate movements on that country’s payments for commodity imports, a bilateral import-weighted index of the nominal effective exchange rate would be appropriate. If the focal point is the study of the effects of exchange rate movements on a particular country’s earnings on account of specific groups of commodities, an index of nominal effective exchange rates based on the distribution of the respective market shares of the principal competitors for such commodities in a given base period would be appropriate.⁴ In this latter case, however, specific weighting procedures may have to be devised to capture potentially relevant third-market effects. This major conceptual and methodological issue is discussed in detail in Section III.

All these considerations, which are relevant to the construction of nominal effective exchange rate indices, were reviewed and extensively discussed by Rhomberg (1976). In particular, his paper provides a number of insights for the proper interpretation of the results of such indices, with the merchandise trade balance being the underlying policy objective. In this respect, he emphasizes (pp. 94–96) that most of the available nominal indices are by definition limited purpose indices. In addition, the paper suggests ways to improve the economic meaning and the operational scope of nominal indices. Such improvements include the use of a general equilibrium model of trade, for example, the MERM.

MERM⁵ Effective Exchange Rate Indices

The MERM may be used to calculate the effective exchange rate change for a given industrial country, which is defined as the change that would induce the same alteration in the trade balance of the selected country expressed in the numeraire currency as that brought about by a given realignment of all exchange rates (Artus and Rhomberg (1973)). Specifically, MERM effective exchange rate indices show the (medium-term) net effects of changes in the exchange rate for a given country on its trade balance, which, taken in isolation,⁶ would have had the same net effect on its trade balance as the whole complex of exchange rate changes that have taken place over a given period. The exchange rate effects are assumed to be determined by three factors⁷—(1) the degree of adjustment of domestic prices and costs to the exchange rate changes; (2) the price elasticities of foreign trade flows; and (3) the aggregate demand management policies followed by the authorities. Another important aspect is that the MERM takes into account not only third-market effects but also all the markets for traded and nontraded goods.

However, the calculation of MERM effective exchange rate indices rests on three major assumptions, which are important for interpreting the results given by such indices. These assumptions are that (1) there are relatively “inflexible” costs and prices in local currency; (2) most of the countries under consideration produce differentiated goods with finite price elasticities of demand in world markets; and (3) central authorities can influence the overall level of nominal final domestic demand.

Similarly, MERM-type indices of nominal effective exchange rates can be calculated on the basis of specifically designed models of multilateral trade for primary producing countries. (See Bélanger (1976).) While the policy question or purpose remains the net effects of exchange rate changes on the trade balance, the underlying trade model is simplified and adapted so that the specific features of primary producing countries can be incorporated. Specifically, such models adopt a commodity-by-commodity approach (as opposed to the basic MERM approach, which distinguishes export products by their place and origin). In addition, as suggested in the latest available version,⁸ they may assume a specific stance of monetary policy in a given country, and, thus, may incorporate inflation rate effects.

Real Effective Exchange Rate Indices

The use of effective exchange rate indices started with nominal indices but was subsequently expanded to include real indices. In their most standard formulation, such indices are nominal effective exchange rate indices “deflated” by (or adjusted for) corresponding indices of relative prices. The use of the real indices started with the perception that much of the variation in the nominal indices was due to inflation differentials between countries. This latter concern was taken into account by deflating the nominal index by an index depicting relative inflation rates. Specifically, the price effects on the exchange rate movements indicated by the nominal index were removed, and it was assumed that the resulting “real” counterpart would adequately measure the “real effects” of exchange rate changes on real phenomena, for example, the trade balance.

Thus, conceptually, the exchange rate movements indicated by the nominal index were implicitly assumed to result from the combination of two separable components, that is, a price change and a pure or real exchange rate change. However, this conceptualization of the exchange rate change gives rise to difficulties about one possible interpretation of the results measured by such indices—that is, the measurement of the real appreciation or depreciation of a given currency. A deflated nominal index no longer embodies an exchange rate concept. This is so because, by definition, the exchange rate is an inherently nominal measure, that is, the relative price of two currencies. This definition holds, even if, in equilibrium, such a measure must reflect the relative purchasing power of the two currencies in the goods markets. In other words, a nominal effective exchange rate cannot be deflated to obtain a real counterpart as is done with real income or any similar real economic series that have a clear-cut price/quantity decomposition. As a result, the calculated values should not be used in any direct sense to measure the extent of the overvaluation or undervaluation of a given currency. At best, such index values may provide some broad indications of the gain or loss in price (cost) competitiveness relative to the selected base period and, thus, only a rough measure of direction of change in international competitiveness.

However, as shown in Appendix I, an alternative formulation is available for any of these real exchange rate indices. Specifically, each of them is, in fact, mathematically equivalent to an index of relative prices deflated by an index of nominal effective exchange rate movements. Viewed in this way, the purpose of such indices becomes more apparent, and the related economic meaning seems to be less subject to the ambiguities surrounding that of the real exchange rate indices in their standard formulation. For instance, changes in the index of domestic to foreign prices adjusted for exchange rate movements are expected to provide some measurement of the changes in the underlying price competitiveness between a given country and its major competitors.

Moreover, also as shown in Appendix I, the construction of these real indices summarizes a purchasing power parity (PPP) type of relationship between relative prices and exchange rates. This relationship requires that relative prices and exchange rates be in equilibrium in the chosen base period, given the exogenous conditioning factors, and that the weighted average of adjusted foreign prices provide the correct equilibrium price for the domestic price in the country under consideration. This requirement suggests that the construction of such indices has a specific theoretical basis, which is likely to have significant implications for interpreting the results.

II. Theoretical Links Between Relative Prices, Exchange Rates, and Balance of Payments in Equilibrium

This section begins with a brief review of the theoretical underpinnings of the real indices, defined as indices of domestic to foreign prices adjusted for exchange rate movements. It continues with a brief discussion of the theoretical links between the concepts of equilibrium prices and exchange rates in relation to balance of payments equilibrium.

Theoretical Underpinnings of Index of Domestic to Foreign Prices Adjusted for Exchange Rate Movements

Underlying PPP relationship

A specific relationship between relative prices and exchange rates is implied in the construction of this index. This relationship can be specified according to either the absolute (i.e., in terms of levels) or the relative (i.e., in terms of changes) version of PPP. As explained by Officer (1976 a), Katseli-Papaefstratiou (1979), and a number of other authors, such a relationship is expected to hold only when one has perfect information in the markets of goods and services and in absence of transport costs, trade impediments, and price discrimination. These considerations are relevant in interpreting the results provided by the real indices. In particular, in equilibrium, the underlying spatial/arbitrage relationship assumes perfect commodity arbitrage across all goods. In turn, the latter arbitrage concept assumes integrated commodity markets for traded goods, high substitutability of nontraded and internationally traded goods, and full employment.

Once the foregoing theoretical conditions are verified, a “world equilibrium price” is expected to be determined unambiguously. Then, the index of domestic to foreign prices adjusted for exchange rate movements is expected to test whether adjusted domestic prices have developed in conformity with such a properly defined world equilibrium price. At the same time, however, the theoretical underpinnings of the relationship say that all the prices involved should converge automatically toward that price. Even so, the calculated values may still end up measuring only the magnitude and importance of trade distortions, cross-country asymmetries, and informational lags rather than underlying developments in international price competitiveness. This is likely to be true if the calculations are based on the prices of homogeneous goods and services. This dilemma does not necessarily imply, however, that there are no (or invariant) competitive relationships among the countries involved (e.g., no (or invariant) relative opportunity costs of production) or no invariant changes in profitability.

Additional problems associated with use of this index

The index of adjusted domestic to foreign prices gives rise to two additional conceptual problems and to two (related) methodological difficulties. A conceptual problem arises with the choice of the proper price indicator for price levels or changes in both the given country and its major competitors. In this respect, the relationship between relative prices and exchange rates does not say much about what is really relevant—Should all the prices of goods or only the prices of the goods (and services) in which a given country trades with the rest of the world be relevant? By the same token, however, it can be shown that the economic meaning of such an index is related to the type of price indicator used or, in other words, that the choice of a specific price indicator is likely to be appropriate only in relation to a well-specified purpose.

The other conceptual problem is how to relate the world equilibrium price and, implicitly, the exchange rate equilibrium for the country under consideration with that country’s balance of payments equilibrium. In this respect, the index assumes that a proper world equilibrium price can be computed; however, such a computed price does not necessarily measure the underlying equilibrium exchange rate concept that is involved. Moreover, by definition, the index would provide only indirectly some indication of the changes in the relative price of tradable versus nontradable goods.

The first major methodological problem, which is implied indirectly by the equilibrium requirement, is how to choose a proper base period (discussed in Implications for choice of base period). The second major problem is how to arrive at a properly weighted price index that would measure world equilibrium price unambiguously (discussed in Section III and Appendix I).

Theoretical Links Between Concepts of Equilibrium Prices, Exchange Rates, and Balance of Payments

One purpose of this subsection is to review briefly the concept of equilibrium exchange rate and its relationship to relative prices and other alternative indicators. Another purpose is to set out (1) the rationale for the calculation and interpretation of relative price indices and alternative indicators and (2) the implications for the choice of the base period.

Balance of payments equilibrium and the concept of equilibrium exchange rate

Balance of payments equilibrium may be defined ultimately in terms of the consistency of an overall balance of payments target (i.e., balance, surplus, or deficit) in a given country with that country’s desired holdings of external reserves. Accordingly, the long-run equilibrium exchange rate may be defined as the exchange rate that is consistent simultaneously with full employment of domestic resources and the overall balance of payments target.⁹ As shown later, this proposition is identical to the proposition that the home country’s relative prices are in equilibrium.

Moreover, in a number of countries (and in virtually all developing countries), balance of payments equilibrium may be defined equivalently in terms of a sustainable external current deficit, given constraints on the availability and terms of inflows of foreign capital. Accordingly, the long-run equilibrium exchange rate would be defined as the exchange rate that is consistent simultaneously with full employment of domestic resources and an external current account situation or target that was, or can be, financed on a sustainable basis. Also, if the long-run equilibrium exchange rate is defined as the rate that equilibrates the external current account or the basic balance, it will vary along with changes in real exogenous factors as well as policy actions.¹⁰

The concept of equilibrium relative price¹¹

The equilibrium relative price is the relative domestic currency price of traded goods compared with nontraded goods, which (1) corresponds broadly to an index of domestic prices compared with world prices and (2) allows for the most profitable proportions for producing each type of goods. Specifically, at this equilibrium relative price, given the world prices (and interest rates), the production possibility frontier (which circumscribes the maximum possible production of traded and nontraded goods), and domestic tastes, both the home-goods market clears and the external trade (or current) account is in equilibrium.

Thus, once an equilibrium relative price is reached, three principal conditions are realized—(1) total expenditure coincides with full employment income; (2) the demand for traded goods equals production (thus achieving external balance); and (3) the demand for nontraded goods equals production (achieving internal balance). Also, as implied by these three conditions, the marginal rate of consumers’ substitution equals that of production substitution, that is, the selling price in each sector equals the respective marginal costs.¹²

Implications for choice of base period

As suggested in the preceding subsection, the interpretation of the calculated relative price (cost) indices would be unambiguous only if the chosen base period were one where at least the selected relative prices (costs) in the reporting country were at or near equilibrium. For that purpose, a careful analysis of the balance of payments will be of primary importance. In this respect, the underlying external trade or current balance is likely to matter; if the trade or current balance was at a “satisfactory” level given the relative cyclical position of the country under consideration and other temporarily reversible factors, actual relative prices (or costs) can reasonably be deemed to have been close to equilibrium.¹³

Also, as suggested in the two preceding subsections, an evaluation of the appropriateness of any given set of relative prices (costs), including the exchange rate, must be based on an analysis of the long-run consistency of such indicators with the simultaneous achievement of balance of payments and full employment equilibrium. Accordingly, all factors that may bear some influence on the actual or targeted outcome of the selected variable for balance of payments equilibrium should be taken into account.¹⁴ Relative prices (costs) may have to be adjusted because of exogenous changes in relative prices, owing to changes in world prices. They may also have to be adjusted because of changes caused by a number of other factors, for example, specific exogenous structural changes.¹⁵

III. Relative Price (Cost) Indices of International Competitiveness—Analysis and Guidelines

Framework for Analyzing Available Indices of Relative Prices (costs) and Alternative Indicators

As suggested in Section II, changes in the relative prices (costs) of traded to nontraded goods have direct and tangible implications for balance of payments equilibrium and, in this context, the long-run equilibrium exchange rate. However, a major conceptual and practical difficulty may still affect the use of such indicators. This difficulty relates to the definition of traded goods. In spite of various attempts, a clear definition has not yet been firmly established.¹⁶ However, available economic literature and practical experience would suggest that there is by now some broad consensus about the fact that (1) the traded goods universe may be significantly broader than actual exports or imports of goods and services and (2) the size of the relevant domestic comparators may differ significantly between exports and imports. For these reasons, available price (cost) indicators to be employed in the relevant index of relative prices (costs) may not be equally adequate for exports, imports, and the import-substituting sector.

In view of these considerations, no attempt is made in this study to regroup individual indicators for both exports and imports into a single indicator. In any case, in practice, it is unlikely that the same price (cost) index can provide an adequate answer to any set of market conditions or policy questions. By the same token, it is likely that not all the available price (cost) indices can provide useful and relatively unambiguous information for the same specific set of market conditions or policy question addressed.¹⁷ The question then is how to use available price (cost) indicators so that the requirement that the related relative price (cost) indices be sufficiently meaningful can be met. One possible approach is to assess how much of the information content of available relative price (cost) indices is lost, compared with the desirable economic properties that indices of adjusted relative prices (costs) would be expected to have.

To be economically meaningful, relative price (cost) indices adjusted for exchange rate changes should, ideally, have three basic economic properties. These are (1) a meaningful base period; (2) adequacy with respect to the set of market conditions involved; and (3) specificity of what they are intended to measure. The first economic property (which was discussed in Implications for choice of base period) implies that the selected base period is one in which relative prices (costs) are not too far from equilibrium.¹⁸ The second property implies that a proper weighting system (i.e., with both a relevant coverage and an appropriate weighting procedure) can be chosen in relation to the competitive relationships and behavior patterns prevailing in the market(s) under consideration. The third property implies that the proper price (cost) indicators can be chosen in relation both to the type of product and the price formation process involved in the markets under consideration and to the specific policy or analytical question addressed. Finally, the study tries to assess the loss in information that is likely to be incurred as available price (cost) indices have to be used as substitutes for theoretically relevant relative price (cost) indices. Appendix II presents the specific features of available relative price (cost) indices and alternative indicators.

Adequacy of Market Structures and Behavior Patterns: Relevant Weighting Procedures¹⁹

Competitive patterns in international export markets and relevant weighting procedures

To be economically meaningful, the index must capture the type of competitive relationship that predominates in the major international markets for which the reporting country is effectively competing. This requirement implies that the selected weighting procedure has to translate differing market structures adequately in terms of both supply and demand conditions.²⁰ The following three basic weighting procedures can be identified in principle. Each corresponds to a different pattern of effective competition in international export markets.

		Adequate
Competitors		Weighting Procedures
(a)	Domestic producers in the importing markets are the main competitors.	(a)	Trade export weights.
(b)	Other exporters selling to the same importing markets are the main competitors.	(b)	Weights that reflect the shares of other exporters in markets of interest to countries under study.
(c)	Both domestic producers and other exporters to importing markets are the main competitors; in this case, all suppliers are relevant.	(c)	Weights that reflect effectively competing shares of domestic producers and of other exporters in markets of interest to the country under study.

		Adequate
Competitors		Weighting Procedures
(a)	Domestic producers in the importing markets are the main competitors.	(a)	Trade export weights.
(b)	Other exporters selling to the same importing markets are the main competitors.	(b)	Weights that reflect the shares of other exporters in markets of interest to countries under study.
(c)	Both domestic producers and other exporters to importing markets are the main competitors; in this case, all suppliers are relevant.	(c)	Weights that reflect effectively competing shares of domestic producers and of other exporters in markets of interest to the country under study.

The standard and perhaps most widely used procedure is based on weights that represent the shares of the major foreign trading partners in the reporting country’s total exports. Such weights can provide useful indicators of export price performance or profitability only if domestic producers in the importing markets are the main competitors for the exports of the reporting country’s producers. In other words, the standard and most widely used approach emphasizes the relative importance of major foreign trading partners as markets on a strictly bilateral basis. The importance of the reporting country as a market for the foreign-produced goods is assumed to be negligible. This situation is depicted by case (a).

In the other polar assumption—case (b)—foreign exporters rather than domestic producers are the main competitors for the reporting country’s exports. Here, appropriate weights would be competitor weights derived on the basis of the respective market shares of each of the competitors of country X in total world exports for the commodities under consideration; the market shares have to be determined on a multilateral basis.

Should the emphasis be on the relative importance of both markets (including the reporting country) to each competitor/ supplier, and all competitors/suppliers (including the reporting country) to all markets, more sophisticated weighting procedures will have to be developed. Such weighting procedures are required in order to take proper care of the third assumption (i.e., case (c)), which recognizes that competition on export markets originates from both foreign and domestic producers and other exporters. Specifically, it is assumed here that there is no perfect competition in world markets or that the products are differentiated.²¹ This assumption is incorporated in the Fund’s MERM.

While the determination of the proper weights is straightforward in cases (a) and (b), it is likely to be more tedious in case (c). However, a number of relevant weighting procedures (Appendix I) have already been developed and used in the Fund and elsewhere.²²

Relevant weighting procedures for import-substituting sector

Ideally, the weighting procedure to be used for the various indicators of price competitiveness and profitability for the import-substituting sector should reflect the relative importance of the various foreign trading partners that are competing for the import substitutes in the reporting country. This requirement implies that the economic basis should be so defined as to include the market shares of the various foreign trading partners in the reporting country’s total imports of the relevant competing imports; moreover, the selected weights should consist only of the products that are competing effectively with well-defined import substitutes in the reporting country. Because of data problems, however, it is unlikely that such an ideal economic basis for the weights can be easily measured in practice.

A readily available approximation is to use the import shares of the major trading partners in the given country’s total imports. However, total imports should be adjusted according to the requirement of economic meaning associated with the type of price (cost) indicators used in the index. Thus, depending on situations, imports²³ that have no or limited domestic substitutes should be excluded from the economic basis that is used to derive the weights. In this respect, the availability or lack of domestic substitutes should be judged in terms of both product and factor markets. In other words, certain imports should not be excluded only because there are no domestic substitutes in the product market. This consideration is particularly important with respect to the exclusion of capital goods from the total imports of most of the developing countries.

Another important consideration to be kept in mind in selecting the weights is the effects of a comparatively large share attributed to the currency of a particular competitor or trading partner, especially in a period in which the currency fluctuated widely. Should such a situation arise, it would be necessary to adjust the relevant price (cost) indicator for the prevailing competitor or trading partner, not only for exchange rate movements but also for “contract prices.” Otherwise, at least in the short run, the movements of the selected index (whether import-weighted or non-oil import-weighted) are likely to exaggerate the underlying changes in international price (cost) competitiveness. This is so because competitors do not generally change contract prices denominated in foreign currencies for the full amount of changes in the exchange rate for their own domestic currency.²⁴

Specificity of What Adjusted Relative Price (cost) Indices Can Measure

Differentiated versus homogeneous products

In situations of imperfect competition,²⁵ the exported products of a given country are sufficiently different from the competing products of the other countries involved in international trade so that the given country’s exports vary in price from those of its major competitors. However, the products in competition remain sufficiently similar so that price changes can affect the volume of the given country’s sales abroad. In such imperfectly competitive markets, domestic exporters and/or producers are faced with smoothly downward-sloping demand curves. Should the demand curve be sufficiently elastic, a price reduction is expected to result in increased sales and, as a result, increasing earnings from exports. Should the demand curve be rather inelastic, a price reduction is still expected to result in increased sales but the earnings are likely to fall. In addition, domestic exporters and/or producers have some influence on setting the prices for their products. In other words, the given country is closer to being a price setter for exports of goods than to being a price taker.

Formally, this situation can be summarized as follows:

Assuming that the price equation of the given country is such that

Δp_x = a_x+α_x Δp^f+ (1 − α_x)Δp^d

with

Δ = (percentage) change
a_x = a constant term
p_x = export prices expressed in domestic currency
p^f = foreign prices expressed in domestic currency
p^d = domestic prices at factory level or domestic producers’ price;

and α_x such that

0 ≤ α_x ≤ 1 = description of arbitrage process between strict price competitiveness and strict cost competitiveness (or profitability)

If α_x = 0, p_x =p^d, and the given country’s exporters and/or producers are clearly in a position to impose their own import prices. On the contrary, if α_x = 1 (i.e., when the so-called law of one price prevails), p_x=p^f, and the export prices of the given country are ruled entirely by foreign prices and by the exogenous inflation components a_x.

This distinction between differentiated and homogeneous products has two important definitional and operational implications. First, whenever the country is a price taker or the products are homogeneous, indices of domestic costs to foreign costs are likely to provide some useful indications as to the profit conditions for the producers of the commodities under consideration and, thus, more meaningful information on international competitiveness than do indices of domestic prices to foreign prices.²⁶ This applies to most developing countries and to large exporting sectors in both semiadvanced countries (e.g., primary commodities and/or manufactures) and some advanced countries (e.g., certain manufactures). Second, as suggested by the arbitrage process, both price and profitability indicators are likely to be relevant in assessing price and cost competitiveness for differentiated products.

Thus, for operational purposes, while indicators of profitability are more relevant than indicators of international price competitiveness for homogeneous products, they are also relevant for differentiated products.²⁷ The difference between what they are intended to measure is one of degree rather than of substance. Specifically, should the home country’s costs rise relative to the competitors’ costs, the home country’s exporters or producers will have to trim their profit margins on foreign sales to a larger extent for homogeneous products than for differentiated products. In other words, the potential for a reduction in market shares abroad is much larger in the former situation. As a result, in the latter case, the home country’s exporters or producers are likely to have more latitude in pricing actions. For instance, they may mark up their export prices to respond to higher domestic costs and at the same time suffer comparatively smaller reductions in their profit margins. They may even be able to maintain their market shares abroad virtually unchanged.²⁸ The result of such pricing actions will depend on their respective relative market power for the products under consideration or on the anticipated effects on profitability and thereby investment requirements and possibilities. In reality, the home country’s exporters or producers are likely to decide to mark up their prices for certain differentiated products and to accept a squeeze on their profit margins for other differentiated products to maintain their overall market shares abroad. Such behavior is likely to be adopted in situations in which wholesale prices for the export commodity under study tend to be aligned or in which international export markets are characterized by relatively competitive oligopolistic market structures.²⁹

Relevant indices of international price competitiveness

Differentiated exports. A relevant index of international price competitiveness is expected to provide a measured indication of how well the reporting country’s actual export prices have performed relative to a weighted average of its major competitors’ prices for comparable exports. Specifically, its purpose is to provide some indication of the potential for a change in the reporting country’s market shares abroad.³⁰ In other words, it is assumed that these selected relative prices matter in the determination of foreign market shares. An index of the home country’s export prices to the competitors’ prices³¹ adjusted for exchange rate changes would be a relevant index for the purpose at hand because it relates exclusively to the prices of goods that effectively enter into international competition.

Differentiated import substitutes. A relevant index of international price competitiveness for the import-substituting sector of a given home country is expected to tell that the higher the home country’s prices of import substitutes are relative to foreign prices of competing imports, the less likely it is that the home country’s wholesalers—and, ultimately, consumers—will wish to buy domestically produced import substitutes. In other words, such an index is expected to indicate to what extent an increase (a decrease) in the home country’s prices relative to foreign prices may create a potential for loss (gain) of the home country’s market shares of domestic substitutes.³² In this respect, a relevant index would be one (adjusted for exchange rate changes) that compares the home country’s “industry selling prices” of import substitutes with the prices of competing imports.

Relevant indices of profitability relative to foreign sales or purchases

Homogeneous and differentiated exports. The principal purpose of an index of profitability relative to foreign sales is to provide some information on how much the given home country can influence its position in foreign markets by maintaining or inducing relatively lower levels of production costs for its exports. In this context, changes in costs are expected to affect the profitability of exporting (i.e., profit margins on exports) and, thereby, influence trade flows directly or indirectly (i.e., through effects on investment), even though changes in costs are not followed through in prices. In other words, the index is expected to tell whether there is some cost incentive that is conducive to a change in a producer’s behavior in continuing production for export markets or investment in additional or new equipment for export production. Specifically, an index of profitability relative to foreign sales is expected to show indirectly how relative cost changes are translated and implicitly distributed between prices and profits.³³ To that effect, a relevant index would be an index of the home country’s total unit costs to the competitors’ total unit costs associated with the production of well-specified exports, adjusted for exchange rate changes.³⁴

Homogeneous and differentiated import substitutes. A relevant index of profitability relative to foreign purchases is expected to tell that the lower the home country’s total unit costs of import substitutes, the more likely it is that the home country’s producers will wish to produce import substitutes rather than to import comparable products. In other words, such an index is expected to provide, indirectly, some indication of the profit incentive for the home country’s producers to continue to produce import substitutes. Unless differences in relative costs can be absorbed on a sustainable basis by offsetting adjustments in the rate of return on capital, a slower increase in foreign unit costs should ultimately be translated into lower prices of importables relative to those of import substitutes. Ultimately, this should result in lower profitability for the import-substituting sector. For homogeneous products, given the prevailing world prices of importables, the calculated values may even suggest that the production of import substitutes should be discontinued. A relevant index of profitability relative to foreign purchases would be an index of the home country’s total unit costs of import substitutes to foreign total unit costs of competing imports, adjusted for exchange rate changes.

Alternative indicators: profitability relative to domestic sales or to production

The indices discussed so far have focused primarily on inter-country price competitiveness or profitability relative to foreign sales or purchases. They are expected to provide only indirectly some indication of emerging changes in the given country’s relative prices (costs) between exports or import substitutes and non-traded commodities. In this respect, they are not expected to tell much about the potential for domestic producers to respond to foreign demand rather than to domestic demand or even to produce.³⁵ A number of alternative indicators (i.e., domestic relative price or cost indices) are expected to provide, directly, some useful information on the incentive to produce for export rather than for domestic markets or even to produce at all. Such information may be obtained in measuring the evolution of profitability relative to domestic sales or to produce exportable goods or import substitutes.

Differentiated exports and import substitutes. For exports, a relevant indicator of profitability relative to domestic sales is expected to tell that the higher the ratio of export to domestic prices, the more likely it is that producers will wish to sell in the export rather than the domestic market. In other words, the index is expected to provide some information on the price incentive to export rather than to sell in the domestic market. This information may be valuable for the direction of trade and the related impact on external adjustment. In this respect, the ratio may be used as a reasonably adequate approximation of the ratio of relative prices of domestic tradables to nontradables, with exportables being the key variable. Ideally, such an indicator is expected to take the form of a ratio of “domestic export prices” to a subset of “wholesale selling prices” for comparable domestically marketed commodities.

For import substitutes, a relevant indicator of profitability relative to domestic sales is expected to tell that the higher the home country’s prices of import substitutes are relative to foreign prices of competing imports, the less likely it is that the home country’s wholesalers will wish to buy domestically produced import substitutes. In other words, the index is expected to indicate to what extent an increase (a decrease) in the home country’s prices relative to foreign prices may create a potential for loss (gain) of the home country’s market share of domestic substitutes. Ideally, such an indicator is expected to take the form of a ratio of the home country’s industry selling prices of import substitutes to the prices of competing imports.

Homogeneous and differentiated exports and import substitutes. For exports, a relevant indicator of profitability relative to domestic sales is expected to tell that the higher the producers’ prices are relative to the retail prices, the more likely it is that the producers will wish to export rather than to sell in domestic markets. Should the level of the producers’ prices be close to that of the corresponding export prices, this ratio would end up measuring the profitability to produce for export. Similarly, should the producers’ prices tend to be increasingly lower than consumer prices, the ratio would indicate that domestic producers may be induced not to produce at all. Such information would be provided by a ratio of the domestic producers’ prices of selected exports to retail prices of comparable products. Should the focus be on profitability to produce for export, an alternative indicator would be one that could tell that the closer total unit costs are to export price levels, the more likely it is that producing for export will become unprofitable and, thus, discouraged. Such a message is expected to be provided by a ratio of export prices to total unit costs.

For import substitutes, a relevant indicator of profitability relative to domestic sales is expected to tell whether there are sufficient price and, thereby, profit incentives to sell import substitutes in domestic markets. The idea behind such an indicator is that the lower the industry selling price of import substitutes, the more likely it is that domestic wholesalers will wish to buy domestically produced import substitutes and that domestic producers will continue to produce substitutes. By the same token, the greater the price differential in favor of import prices, the more likely it is that domestic wholesalers will be induced to buy competing imports and the less likely it is that domestic producers will be induced to produce import substitutes. Should imports become highly profitable, domestic wholesalers and even some producers might be induced to enter into direct imports. A relevant indicator would be the ratio of the import prices of competing imports to the industry selling prices of import substitutes. Should the focus be on profitability to produce import substitutes, an alternative relevant indicator would be one that could tell that the lower the given industry selling prices and the higher the costs to produce, the less likely it is that domestic producers will be willing to produce import substitutes and the more likely that they may be induced either to produce nontraded commodities or to enter into direct imports. Such a message is expected to be provided by the ratio of the industry selling prices of import substitutes to the producers’ costs for producing such substitutes.

Available Indices: Use of Substitutes and Related Implications

In practice, any of the relevant indices (and alternative indicators) discussed in the subsection, specificity of what adjusted relative price (cost) indices can measure, are not likely to be available, primarily because the required price (cost) indicators either are not readily available or are not available at all.³⁶ As shown in Appendix II, various proxies have to be used for the relevant price (cost) indicator, given the type of products and markets (i.e., type of competition that predominates) and the policy or analytical question addressed. In many instances, the second-best proxy (e.g., unit labor costs or wholesale prices) may in turn have to be approximated by consumer prices.

Such approximations imply some loss of information in terms of the adequacy of the economic meaning of the price (cost) indicator that is ultimately used and that of the price (cost) indicator to be used in the relevant index of price competitiveness or profitability. In other words, a single price measure is deemed to be appropriate under different market structures and for different policy or analytical questions.³⁷ This proposition implies in turn that specific assumptions must be made on the functional relationship between the price (cost) indicator used and the truly relevant price (cost) indicator. Such assumptions involve elements of judgment that may not necessarily be supported by reality and usually cannot prevent the calculated values from overstating or under-stating what the indices are expected to measure. In addition, the specific features of the price (cost) indicator used in terms of comparability, coverage, and reliability³⁸ may further cloud the meaning of the calculated values.

For instance, using consumer prices as a proxy for producers’ costs in an index of profitability relative to foreign sales or purchases implies that they are adequate proxies for factor (i.e., wage) costs as measured in both the numerator and the denominator of the index. It is implied that they can approximate the behavior of export (import) prices so that profit margins are reduced (enlarged) in case of depreciation (appreciation). Moreover, in this context, the resulting index of relative consumer prices is implicitly assumed to be a relevant measure of the prices of traded to nontraded goods, while it can in fact measure only relative price levels.³⁹ It may be argued, however, that because the rationale for using consumer prices is well established in this particular case, an index of the home country’s consumer prices to foreign consumer prices may still be deemed to approximate the relevant index of profitability relative to foreign sales or purchases reasonably well. Even though changes in costs as measured by consumer prices are not entirely or quickly followed through in export (or import) prices, they may still be deemed to affect the profitability of exporting or of selling domestically (or even of producing) import substitutes and, thereby, to influence trade flows.

IV. Concluding Remarks

Several relative price (cost) indices adjusted for exchange rate movements and domestic relative price (cost) indices have been defined and discussed in this study. The overall purpose of the study was to make explicit the conditions under which such indicators could be helpful in studies on the adequacy of the level of a country’s exchange rate. The study discusses a number of conceptual and methodological problems that are associated with such indicators and of which any potential user should be aware.

Available indicators should be used only in conjunction with a balance of payments analysis for the country under consideration. The purposes of such an analysis are (1) to set out the relative contribution of exports and import substitutes of goods and/or services to the balance of payments outcome; (2) to evaluate the extent to which relevant price and/or cost relationships are consistent with the underlying trade or external accounts and full employment; (3) to help to determine the “normative equilibrium significance” of most of the available exchange rate, price, or cost indices and, thereby, to select an appropriate base period; (4) to assess whether the principal exports or import substitutes of goods and/or services are differentiated or homogeneous products and/ or whether the country under consideration is a price setter or a price taker for its exports or import substitutes; (5) for inter-country comparisons, to determine the type of competitive relationships involved in foreign markets that are of interest to the country under consideration and, thereby, to help to select the most appropriate weighting procedure for the relevant competitors’ (foreign) exchange rate and price (cost) indicators; and (6) to set out the specific policy or analytical question(s) of particular interest to the potential user and, thereby, to select the most appropriate price (cost) indicator(s) to be used in the relevant indices.

Relative price (cost) indices adjusted for exchange rate movements and domestic relative price (cost) indices discussed in this study are shown to have a relatively clear economic meaning in relation to well-defined purposes and subject areas. Specifically, the study exemplifies that there are as many relative price (cost) indices adjusted for exchange rate movements and domestic relative price (cost) indices as there are analytical or policy questions that may be addressed and related economic situations. At the same time, as shown in available indices: use of substitutes and related implications and Appendix II, each index can fulfill only a limited number of well-defined purposes without losing too much of its economic meaning. In this respect, relative price (cost) indices are shown to be indicators of either price competitiveness or profitability and, in the latter, of profitability relative to foreign sales, to domestic sales, or to produce. Along these lines, the indices are expected to be used as a starting point to give some indication of the broad trends in a country’s international competitiveness. In particular, increasingly large deviations in the calculated values relative to a properly selected base period would suggest that the appropriateness of a given exchange rate should be discussed.

The calculated values of relative price (cost) indices adjusted for exchange rate movements and of domestic relative prices (costs) should always be interpreted with caution. In no case should the calculated values be elevated into firm norms that would exactly measure the extent of the need for a change in the level of the current exchange rate. This is due to a number of reasons: (1) the degree of approximation involved in the selection of the index that can be used in practice; (2) the shortcomings inherent in the price (and cost) statistics that are available in practice, especially if adjustments must be made; and (3) for intercountry comparisons, the averaging technique used.

All in all, it is suggested that several relevant indices of relative prices (costs) adjusted for exchange rate movements and domestic price (cost) indices should be used together. Only a combination of such calculated values can be expected to help to remove the potential for conflicting signals that may be provided by any of the available indices taken in isolation, even though the purpose at hand and the subject area are well specified. Specifically, the resulting combined information, together with a forward-looking analysis of the balance of payments, is expected to help to set a background against which the question of the adequacy of a given exchange rate could be addressed. On this basis, as emphasized in this study, sufficient and reasonably consistent indications could be provided on international price competitiveness, profitability relative to foreign sales and domestic sales, and profitability to produce. In addition, the selective use of relative price (cost) indices may provide useful signals about the possible need for specific policy actions that may help to reverse unfavorable trends in underlying price competitiveness and profitability.

I. Derivation of Effective Exchange Rates, Weighting Procedures, and Operational Implications of Mathematical Formulations

Derivation of Nominal and Real Effective Exchange Rates

Nominal effective exchange rate—derivation of index⁴⁰

It is well accepted that there can be no measurement without theory, yet none of the classic references on nominal effective exchange rate (EER) indices offers an explicit derivation of the index put forward.⁴¹ Thus, in the present context of a reappraisal of methodological and interpretative issues relating to the EER index, a natural first step is to establish this link between theory and practice by a simple and explicit derivation of the index in question. It is assumed here that the focus is on the use of the EER index for assessing the impact of exchange rate movements on export competitiveness so that the problem can be narrowed to the derivation of a bilateral export-weighted EER index.⁴²

Given this objective, by analogy to the construction of the Laspeyres price index, the following question can be asked:

Consider the reporting country’s foreign exchange receipts from exports at time 0 (the base period). Holding constant the price and quantity of these exports, what would be the change in the value of these export earnings caused solely by the change at time 1 in the exchange rates of the reporting country and its major export partners?⁴³

Thus, by construction, the index focuses on the pure exchange rate effect, allowing only the foregoing limited issue to be addressed. To answer the question presented above, all that one must do is to follow a derivation similar to that of the Laspeyres index. Let $X_{0}^{p}$ be the value of exports to the p th trading partner in the base period (0), expressed in that partner’s currency. Let $e_{1}^{p}$ and $e_{0}^{p}$ be the dollar values ($/currency) of one unit of the p th partner’s currency in period 1 and in the base period (0), respectively, and $e_{1}^{r}$ and $e_{0}^{r}$ be the dollar values ($/currency) of one unit of the reporting country’s currency in period 1 and in the base period (0), respectively. Then, to compare the change in the value of the base period’s export earnings (from all partners) owing to exchange rate movements, the following ratio is formed

\begin{matrix} E = \frac{\underset{p}{Σ} X_{0}^{p} (e_{1}^{p} / e_{1}^{r})}{\underset{p}{Σ} X_{0}^{p} (e_{0}^{p} / e_{0}^{r})} \cdot 100 & (1) \end{matrix}

where subscripts refer to the time period and superscripts to the country. The price and quantity components ( $X_{0}^{p}$ ) of the value of export receipts are held constant and only the relative exchange rates are changed. Through simple manipulation, equation (1) can be written in a form readily recognizable from the effective exchange rate literature

\begin{matrix} E = \underset{p}{Σ} \frac{W_{0}^{p}}{\underset{p}{Σ} W_{0}^{p}} (\frac{e_{1}^{p}}{e_{0}^{p}} / \frac{e_{1}^{r}}{e_{0}^{r}}) \cdot 100 & (2) \end{matrix}

where

W_{0}^{p} = X_{0}^{p} \cdot \frac{e_{0}^{p}}{e_{0}^{r}}

In formulation (2), the index is shown to be simply the bilateral export-weighted index of the nominal effective exchange rate described by Rhomberg (1976, p. 95).⁴⁴ The ratios $e_{1}^{p}$ / $e_{0}^{p}$ and $e_{1}^{r}$ \ $e_{0}^{r}$ are the indices of changes from the base period in p’s and r’s numeraire exchange rates, respectively.

Nominal effective exchange rate—adjustment for inflation differentials

Consider the nominal index rate derived in formulations (1) and (2). Deflating equation (1) by the ratio of price changes from the base period in the partner countries to that in the reporting country gives, after a number of mathematical manipulations,

\begin{matrix} R = \underset{p}{Σ} Z_{p} (\frac{e_{1}^{p r}}{e_{0}^{p r}}) / (\frac{p_{1}^{p r}}{p_{0}^{p r}}) \cdot 100 & (3) \end{matrix}

where $Z_{p} = W_{0}^{p} / \underset{p}{Σ} W_{0}^{p}$ is the bilateral export share; $e_{0}^{p r} = e_{0}^{p} / e_{0}^{r}$ and $e_{1}^{p r} = e_{1}^{p} / e_{1}^{r}$ are the bilateral exchange rates of the partner countries to the reporting country at time 0 and time 1, respectively; and $p_{0}^{p r} = p_{0}^{p} / p_{0}^{r}$ and $p_{1}^{p r} = p_{1}^{p} / p_{1}^{r}$ are the ratios of export prices of the partner countries to those of the reporting country at time 0 and time 1.

Equation (3) can, in turn, be easily expressed in a more reduced, mathematically equivalent form, that is,

\begin{matrix} R = \underset{p}{Σ} Z_{p} (r_{1}^{p} / r_{0}^{p}) & (4) \end{matrix}

where $r_{1}^{p} = e_{1}^{p r} / p_{1}^{p r}$ and $r_{0}^{p} = e_{0}^{p r} / e_{0}^{p r}$ so that R is a weighted sum of real exchange rates, as usually defined in the literature.

Weighted bilateral index of relative export prices adjusted for exchange rate changes

Assuming that what matters is the price of the home country’s exports and the foreign prices of comparable exports, both expressed in the same currency (say, the U.S. dollar), the following ratio of the foreign trading partner’s prices to the home country’s prices can be constructed

\begin{matrix} P = (p^{p} / e^{p}) / (p^{r} / e^{r}) & (5) \end{matrix}

Ratio (5) can easily be shown to be mathematically equivalent to

\begin{matrix} R = (e^{r} / e^{p}) / (p^{r} / e^{p}) & (6) \end{matrix}

or, in a more sophisticated presentation to equation (3), that is, the nominal effective exchange rate adjusted for inflation differentials.

Weighting Procedures

Relevant weighting procedures for differentiated products

Weighting procedures similar to the one underlying the MERM weights could be developed. One such MERM-type procedure could be spelled out as follows:⁴⁵

W_{x k} = Σ_{j = 1}^{m} \frac{X_{x j}}{X_{x} .} Σ_{i = 1}^{n} \frac{{i X}_{x j}}{{. X}_{x j}} \cdot \frac{{i X}_{k j}}{i X . j}

with

iX_xj = supplies of the ith commodity to the jth market originating from country x
n = number of commodities
m = number of markets to which countries x and k export ith commodity
x,k = competitor countries

and

· = summation over the relevant index

Another possibility is to use the basic double-weighting formula developed by the OECD:⁴⁶

W_{x j} = \underset{i \neq j}{Σ} \frac{X_{x i}}{X_{x} .} \cdot \frac{M_{i j}}{M_{i}}

where

X_xi/X_x = share of ith country in x’s exports
M_ij/M_i = share of ith country’s imports supplied by j

The foregoing two procedures could be used for industrialized countries and perhaps some semiadvanced developing countries. However, a number of underlying simplifying assumptions are involved.⁴⁷

Relevant weighting procedures for homogeneous products

Whenever a reporting country’s exports are relatively homogeneous, not much variation in prices can exist among competing suppliers. However, as explained earlier, variation in relative costs may matter. As a result, a proper weighting procedure would also be required in these cases; the MERM-type weighting procedure or the OECD double-weighting formula, which are market-oriented procedures, could also be used. In this respect, it should also be stressed that the use of simple trade weights is likely to be inappropriate, especially for primary commodities, since they would not reflect the true underlying competitive relationships in the markets that are of interest to the selected reporting country.⁴⁸

Another possibility is to develop a weighting procedure with a commodity-oriented specification, as has been done by Bélanger (1976) and Feltenstein, Goldstein, and Schadler (1979).

Also, a commodity-oriented specification could be given to the OECD double-weighting procedure, which could be computed as follows:

W_{k j} = \underset{l}{Σ} \frac{X_{k l}}{X_{k} .} \cdot \frac{M_{j l}}{X_{l}}

where

X_xl/X_x = share of the lth commodity in x’s exports

and

X_jl/X_l = share of jth country in world exports of l

Intercountry Comparisons: Operational Implications of the Mathematical Formulations

The mathematical formulation used in the calculation of indices may have a considerable influence on the calculated values of the indices at two levels—the computation of the relative price (cost) component of the index and the averaging method used in the index taken as a whole.

As to the computation of the relative price (cost) component, two approaches are available mathematically. One is to compute an index of relative prices (costs) and an index of exchange rate changes, using the same weighting procedure, and then combine the two indices to obtain the selected index of adjusted relative prices (costs). The other possibility is to combine the proxy for the relative price (cost) term of the index and the exchange rate for each individual country or competitor involved, including the reporting countries, and only then combine the resulting adjusted ratios using the most appropriate weighting procedure. The first possibility, in a geometric formulation, has the property that the variances of the results obtained from either of the two indices can be decomposed into the constituent variances of the exchange rate and the relative price indices and the covariance of the two. The second possibility is in many respects more restrictive in scope. Mathematically, it can only tell something about the geographic origin of the distortions indicated by the calculated values of either of the two indices. Owing to this, however, it may be economically more meaningful.

As to the averaging method to be used in the index, two basic formulations are available—the basket or linear formulation, which may be either an arithmetic-averaging or a harmonic-averaging technique, and the geometric-averaging formulation. The averaging method used in the construction of the index of relative prices (costs) or real effective exchange rate has important quantitative implications for the calculated values of the index; thus, the two most widely used techniques—arithmetic-averaging and harmonic-averaging—both have inherent biases (Brodsky (1980) and Pinçon (1980)). Only geometric averaging can avoid these quantitative differences, since it treats depreciating and appreciating currencies in an entirely symmetrical manner. This property follows from the fact that a geometrically averaged index is a linear function of the component bilateral exchange rate indices so that “equivalent” depreciating changes and appreciating changes cancel one another.⁴⁹ As a result, the relative change between any two dates can be measured by simply comparing the corresponding levels of the calculated values of the index. For any given weighting procedure, the percentage changes are independent of the base dates, and there is an element of uniqueness in the determination of relative changes. Moreover, the geometric method meets all the basic statistical requirements of the ideal index number.⁵⁰ The use of the geometric-averaging technique is particularly appropriate for countries with a strong structural trend, especially if no equilibrium period can be clearly selected for the economic basis required for the weights on sufficiently reliable grounds. However, its economic interpretation cannot be made directly in terms of levels as for both the arithmetic-averaging and harmonic-averaging techniques.

By contrast, neither the arithmetic-averaging nor the harmonic-averaging techniques have uniqueness in determining relative changes, and the latter may be heavily influenced in magnitude and/or direction by the choice of the base period. This major problem results from the asymmetric treatment of rapidly decreasing and increasing foreign prices (costs) and/or exchange rates vis-à-vis the reporting country’s prices (costs) and/or exchange rate. This consideration may be particularly important for interpretative purposes if one or two of the competitors are assigned relatively large weights.⁵¹

II. Available Relative Price (Cost) Indices Adjusted for Exchange Rate Movements and Alternative Indicators

Available Relative Price (cost) Indices of Export Competitiveness

Existing relative price (cost) indices

A number of indices of relative prices, adjusted or unadjusted for exchange rate movements, have been either developed or computed in the Fund. These are indices of relative prices for intercountry price and cost comparisons of manufactured goods.⁵² They are (1) domestic export unit values to foreign export unit values; (2) domestic wholesale export unit values to foreign wholesale prices; (3) domestic unit labor costs to foreign unit labor costs, including “normalized” unit labor costs; and (4) domestic price deflator (for value added) to foreign price deflators. Similarly, the OECD has either developed or used a number of indices of relative prices (costs) to measure changes in international price and cost competitiveness. These indices include two indices of relative prices and one index of relative costs, which involve a standard PPP relationship. The two indices of relative prices, namely, domestic export unit values to foreign export unit values and domestic wholesale prices to foreign wholesale prices, are essentially two measures of price competitiveness.⁵³ Similarly, the index of relative costs (i.e., an index of domestic costs to foreign costs) is essentially an index of international cost competitiveness. In practice, the first two indices are proxied by indices of “derived” relative prices based on subindices of either consumer prices or gross domestic product (GDP) deflators. The third index is proxied by an index of smoothed domestic unit labor costs to smoothed foreign unit labor costs, where labor costs are based on either a four-quarter moving average adjustment or the so-called trended productivity.⁵⁴

All the preceding indices of relative prices (costs) focus on manufactured goods and are expected to depict relevant developments in international price (cost) competitiveness. However, because their common purpose is intercountry comparisons, they can tell little—and that only indirectly—about underlying developments in relative prices (costs) of traded goods relative to nontraded goods within the country under consideration. Similar remarks would apply to most of the indices of relative prices used in available studies on export competitiveness for manufactured goods that were recently carried out by the EEC—Robinson, Webb, and Townsend (1979)—and central banks—Etienne and others (1980). All in all, relatively little use has been made of domestic relative price (cost) indices of traded to nontraded goods. For only one country,⁵⁵ the study involved the use of a ratio of domestic export prices to wholesale prices as an alternative indicator of price competitiveness of exports.

Relative price indices of international price competitiveness

Index of export unit values of home country to those of competitors. In this index, the price term of the “ideal” index is proxied by export unit values.⁵⁶ The latter are derived from actual data on values and quantities⁵⁷ and reflect the actual prices received for the goods actually traded. They may also refer exclusively to narrowly specified policy or analytical questions, for example, price competitiveness in manufactures.

Export unit values have a number of basic well-known deficiencies.⁵⁸ In addition, the calculated values may not necessarily reflect underlying changes in price competitiveness for at least two reasons. One reason is the inclusion of different export taxes in actual data on export values. The other reason is that export prices are not necessarily raised or reduced significantly in relation to competitors’ export prices. Even if cost developments would warrant such actions, domestic exporters and/or producers may prefer to trim their profit margins. As a result, even though its economic meaning is relatively clear, the index will measure changes in price competitiveness that may not properly reflect changes in underlying competitiveness. Despite these deficiencies, such an index may serve as a useful starting point for assessing the competitiveness of specified categories of exported goods.

Index of wholesale prices of home country to those of competitors. A priori, this index may stand as a readily available alternative candidate to the index of the home country’s export prices to the competitors’ export prices. Owing to their broader coverage, wholesale prices may reflect underlying price developments for potentially exportable goods. By contrast, export unit values, whose coverage is limited to goods actually traded, are more prone to reflect past price performance. However, apart from the statistical deficiencies,⁵⁹ WPIs may include a relatively large number of nontraded goods and some imported goods for domestic consumption. In addition, such indices may pick up changes in indirect taxes and subsidies that are actually levied on imports and not charged on exports.

Conceptually, wholesale prices may approximate export prices only if they are relatively close to domestic producers’ prices of exports at the factory level in terms of both coverage and commodity composition. Otherwise, wholesale prices may overstate or understate underlying export price developments in the reporting country relative to its major competitors. Once the above-mentioned condition is verified,⁶⁰ and some of their inherent deficiencies⁶¹ are removed, the index of the home country’s wholesale prices to competitors’ wholesale prices may serve as a useful indicator for studying a narrowly defined subject (e.g., international price developments in exports of manufactures).

Cost indices of profitability relative to foreign sales

Index of unit labor costs of home country to those of competitors. In this index, the cost term is proxied by unit labor costs. The index of the home country’s unit labor costs to the competitors’ unit labor costs is a cost-based measure of profitability of foreign sales, which abstracts from changes in profits. This qualification stems from the definition and construction of unit labor cost indices. Such indices are generally defined as the ratio of all labor costs⁶² to the volume of output produced by that labor; more specifically, they may be measured as the ratio of total hourly remuneration to real value added (of output) per man-hour (i.e., productivity). Thus, it is implicitly assumed that unit labor costs form the major component⁶³ of the total costs involved per unit of output, even though other factors may significantly influence the overall cost formation. This assumption implies that the incidence of other costs⁶⁴ is sufficiently similar at the margin across the competing countries under consideration that changes in labor costs could be effectively deemed to be the principal cause of cost variation between competing countries.

The standard index of the home country’s unit labor costs to the competitors’ unit labor costs has one major disadvantage. It often embodies erratic movements, which tend to cloud the information that it is expected to provide and may even give a wrong signal about profitability developments.⁶⁵ Such erratic movements may be due to the quality of available data on labor costs but also to leads-and-lags relationships; for example, the responses of productivity to cyclical changes in demand pressures are likely to be different from those of hourly remuneration to the same pressures.⁶⁶ Without the implied adjustments, the calculated values of the standard index may well provide the wrong signals about the evolution of profits.⁶⁷ Such adjustments are likely to be required in view of the almost inevitable differences in erratic movements among the countries under consideration that are due to differentiated cyclical situations and changes.

The use of the standard index has another disadvantage, which is related to problems of comparability among available indices of unit labor costs.⁶⁸ In particular, the definition of unit labor costs and related coverage may differ widely from one country to another. This inherent potential shortcoming may induce more pronounced differences in the composition of factor inputs and their relative productivity trends. In addition, reasonably good and internationally comparable series are available after some considerable time lags. However, part of the potential shortcomings of the index of the home country’s unit labor costs to the competitors’ unit labor costs is expected to be alleviated for developed industrial countries, where production patterns tend on the whole to become increasingly comparable. In this respect, it may be deemed that this index as well as a similar index that incorporates a concept of smoothed or normalized unit labor costs is a reasonably good proxy for the index of domestic total unit costs to foreign total unit costs.⁶⁹

Index of normalized unit labor costs of home country to those of competitors. In this index, unit labor costs are adjusted for cyclical swings in productivity, which are assumed to be of a transitory nature. Such adjustments may be made in different ways. For instance, in earlier practices, “normal” productivity was equated with the log-linear trend of actual productivity during a specified period. Now, in the Fund and elsewhere, normalized unit labor costs are defined in terms of actual hourly compensation divided by potential output per man-hour or potential productivity.⁷⁰ The resulting normalized index is expected to help to narrow down the type of information initially provided by the standard index to more plausible signals.

However, given the assumption of reversibility involved in the construction of the normalized index, the interpretation of the results should be assessed accordingly. Specifically, should economic recession persist or the pace of recovery be excessively slow and uncertain, the calculated values of the index may have to be interpreted with caution for short-term purposes. This difficulty may be, however, less of a problem over the medium to long run, since the element of “normalcy” involved in the index is likely to be properly corrected over time.⁷¹

Apart from the problems of the availability of data mentioned earlier, one major practical disadvantage with the normalized index is that normalized unit labor costs are not readily available. Specific and more or less complex procedures of computation are likely to be involved in deriving such indices. In particular, the method of calculating potential output requires a number of restrictive assumptions,⁷² which may not be acceptable or appropriate in a number of (especially developing) countries.

Index of consumer prices of home country to those of competitors. Used as a proxy for the index of the home country’s total unit costs to the competitors’ total unit costs, the index of the home country’s consumer prices to competitors’ consumer prices attempts in fact to measure relative producer costs. Should domestic inflation (measured by the CPI) go up, the index is expected to indicate that the home country’s producer costs have increased relative to those of its competitors. In other words, the index is intended to say that above-average rises in the home country’s production costs tend to induce a reduction in the profit margins of its producers relative to those of foreign producers, unless the faster increases in costs are offset by larger domestic productivity gains. In turn, reduced profit margins are expected to induce a relatively larger reduction in domestic supply, which may eventually result in a smaller share of world production and declining world market shares. Thus, it is implicitly assumed that consumer prices are relevant to the determination of wages and other factors of production, that is, that they have some effects on both unit labor costs and other unit costs. It is also implicitly assumed that no considerable time lags are involved in the adjustment of production costs to consumer prices.

By definition, however, CPIs reflect patterns of consumer spending that may differ widely from one country to another, especially in intercountry comparisons involving developing and developed countries.⁷³ In addition, CPIs tend to include a relatively large proportion of nontraded and imported goods that are consumed locally and to have a number of other deficiencies.⁷⁴ All these inherent shortcomings have to be closely analyzed before using CPIs and must be borne in mind in interpreting the calculated values.

Index of GDP deflator of home country to those of competitors. The index of the home country’s GDP deflator to the competitors’ GDP deflator can be viewed as another more or less readily available alternative ratio to that of the home country’s total unit costs to the competitors’ total unit costs.⁷⁵ Specifically, it includes a composite indicator of the cost per unit of value added of all primary factors of production that enter into the production of domestically produced goods for export.⁷⁶ Hence, the calculated values are expected to provide some valuable signals on the underlying developments in profitability in the given home country relative to similar developments in competing countries. Such an index may also serve as a readily available index for the study of a well-defined segment of the economy, such as certain goods and/or services (e.g., tourism).

By definition, however, the use of this index is likely to be relevant mostly for the study of developments in profitability over the long run. Moreover, since GDP deflators are computed as quotients of the current and constant prices of value added, major difficulties with data and computation are virtually unavoidable.⁷⁷ In particular, the computation of value added at constant prices for certain types of goods and services may not be sufficiently reliable for most developing countries and even for some developed countries.⁷⁸

Despite these and other limitations, GDP deflators present a number of advantages about profitability relative to foreign sales.⁷⁹ They refer only to domestically produced goods and tend to cover virtually all such goods and services with a limited risk of double counting. Although they do not represent final product costs, they may provide some useful indications of the formation of final prices (e.g., export prices of goods and services). In this respect, they may help to measure the specific contribution of the given country to the formation of the final prices of its exports. Such information is likely to be particularly valuable for small open economies, whose exports have a relatively large import component.⁸⁰

Alternative indicators: profitability relative to domestic sales or to production

Ratio of export unit values to wholesale prices. A specific example of such a proxy is provided by the ratio of export unit values of manufactures to their wholesale prices; this ratio is more or less readily available in most of the developed countries.

Owing in part to the price indicators used, the ratio of export unit values to wholesale prices has another deficiency. The price indicators used in the ratio are not comparable: while the numerator tends to refer to past periods, the denominator tends to refer to current periods.⁸¹ However, wholesale prices also measure actual prices of nontraded goods (although with a small lag); in this respect, the ratio of export unit values to wholesale prices may be deemed to approximate a ratio of traded to nontraded prices reasonably well.

Thus, in interpreting the results, it should be kept in mind that if the WPI is used as a proxy for the denominator, the calculated values are likely to overstate or understate the true price incentive offered to domestic producers to sell in domestic markets. Ideally, the WPI should be adjusted so that the composition and coverage of both the numerator and the denominator are roughly comparable. In addition, the impact of export taxes as well as that of indirect taxes should be properly assessed before the calculated values are interpreted.

Ratio of export unit values to consumer prices. The ratio of export unit values to wholesale prices may, in turn, be approximated by a ratio of export unit values to consumer prices, excluding the prices of imports. However, should import prices be included, the ratio would no longer approximate a proper measure of the relative prices of domestic exports to nontradables; specifically, the calculated values could be significantly biased. Apart from this problem, in interpreting the results it should be kept in mind that (1) national CPIs generally include a number of indirect taxes and subsidies and (2) a so-called productivity bias may be involved as well.

Ratio of export prices to unit labor costs. Another possible candidate would be the ratio of export prices to total unit costs. The idea behind this measure is that the lower that export prices are relative to total unit costs, the more likely it is that producers will wish to produce for the domestic rather than the export market. The implicit assumptions behind such a measure are that (1) total unit costs are roughly similar across the economy and (2) export prices move relatively closely with wholesale prices or even domestic prices.

Other possible indicators. The ratio of the price deflator for exports of goods and services to the GDP deflator could be another useful indicator of profitability relative to domestic sales.⁸² By definition, the GDP deflator, which measures the price movement of all domestic production, is a measure of the aggregate of tradable and nontradable domestic production. As such, it may be considered as a reasonable proxy for assessing the cost behavior of tradables cum nontradables in relation to tradables. However, because the numerator includes both tradables and nontradables, the resulting ratio may overstate or understate the true developments that are directly relevant to the behavior of exports cum non-exports in relation to exports. Also, differential productivity may be another serious problem and should be properly assessed before interpreting the calculated values. In some circumstances, however, this problem could be partially resolved by recourse to a ratio of the price deflator for exports of goods and services to the GDP deflator multiplied by the ratio of average labor productivity in the manufacturing sector to average labor productivity in the economy as a whole.

Available Relative Price (cost) Indices of Competitiveness for Import-Substituting Sector

International price competitiveness

Index of home country’s wholesale prices to foreign export unit values. In this index, the price component of the denominator is proxied by export unit values used as a proxy for the relevant import unit prices. To provide some plausible and not too ambiguous information, the comparability of the price components of this index in terms of coverage should still be verified. In particular, the prices of products that have no import substitutes in the domestic market of the reporting country should be removed both from the price indicators and from the economic basis that is used to derive the weights for averaging the foreign price indices.

Index of home country’s wholesale prices to foreign prices. This index represents a further step away from the previous index, where export unit values are proxied by the foreign wholesale prices. Apart from the lack of comparability involved in the construction of any of the available national WPIs, this index in fact measures the prices of domestic traded and nontraded goods relative to foreign traded and nontraded goods. Even if the impact of the different indirect taxes and subsidies is properly assessed and taken care of, the calculated values are likely to overstate or understate true international price developments and may provide unreliable signals on the competitiveness of the given home country’s import-substituting sector.

Cost indices of profitability relative to foreign purchases

Index of home country’s unit labor costs to foreign costs. This index represents a first step away from an index of the home country’s unit labor costs of import substitutes to foreign unit labor costs of competing imports, with the cost component being proxied by unit labor costs. Like the relevant index discussed in Relevant indices of profitability relative to foreign sales or purchases, this index is expected to provide some indications of how higher costs may adversely affect the profit margins of enterprises that produce import substitutes. As such, this index implicitly assumes similar capital costs and similar marginal substitution between capital and other factor inputs, including no significant changes in the capital/labor ratio.⁸³

This index may be improved by replacing unit labor costs with normalized unit labor costs. However, the required data are likely to be available only for manufactures and for the developed countries and perhaps some semiadvanced developing countries. In most other countries, even if the focus is only on manufactures, this index will have to be approximated by an index of the home country’s consumer prices to foreign consumer prices.

Index of home country’s consumer prices to foreign prices. In this index, the cost component is proxied by the national CPIs. Apart from the deficiencies that are inherent in CPIs,⁸⁴ the calculated values may well indicate movements in relative prices that do not reflect underlying price trends and changes in profitability.⁸⁵

Conceptually, the domestic CPI may be used as an acceptable proxy for factor (especially wage) costs only if (1) the foreign CPIs have some influence on the costs of the competing imports and (2) the compared production structures are roughly comparable in terms of labor content. In this respect, national CPIs used as a proxy for the prices of import substitutes have to be relevant in terms of both product and factor markets.⁸⁶ This proposition implies that the CPIs under consideration should be adjusted accordingly so that the impact of irrelevant prices is excluded. As explained in Relevant weighting procedures for import-substituting sector, this conceptual constraint has an important implication for the weighting procedure to be used in averaging the foreign CPIs.

Moreover, this index may provide indications that (at least in the short run) may exaggerate changes in the prices of import substitutes relative to those of nontraded goods. Such a result is likely to occur in situations where foreign competitors for the domestic market of the home country under consideration decide not to change their contract prices denominated in foreign currencies for the full amount of the changes in the exchange rate. Instead, they may decide to trim their profit margins somewhat in setting contract prices in their respective currencies so that only some of the change in the exchange rate is absorbed.⁸⁷ In such circumstances, as suggested in Relevant weighting procedures for import-substituting sector, it would be useful to employ an alternative index of the home country’s CPI to foreign CPIs, where the foreign CPIs are adjusted for differences between prices for domestic and foreign sales.

Alternative indicators of profitability relative to foreign purchases or to production

Ratio of import unit values to wholesale prices. This ratio represents a first step away from a ratio of import unit values of competing imports to the wholesale prices of import substitutes. In this ratio, WPI not only approximates the wholesale prices of import substitutes but also includes the wholesale prices of exports, imports, and nontraded goods. Moreover, in this ratio, import unit values refer to the import unit values of both imports competing with import substitutes and other imports for which there are no (actual or potential) domestic substitutes. Thus, the ratio actually measures the changes in the prices of all imports relative to the changes in the prices of importables (imports plus import substitutes), exports, and nontraded goods. In this respect, in interpreting the calculated values, it should be kept in mind that they are likely to overstate (or understate) the underlying changes in the relative prices of import substitutes to competing imports. Also, before the calculated values are interpreted, the impact of customs duties and other related taxes, as well as of the indirect sales tax, should be assessed properly. This ratio is, to some extent, analogous to that of the export unit values of exports to the wholesale prices. Hence, owing to the shortcomings inherent in the price indicators used, it suffers from similar drawbacks.

A specific example of such a ratio is the ratio of import unit values of (finished) manufactures to the wholesale prices of manufactures. Given the narrow and well-specified subject area, part of the drawbacks associated with the proxy ratio of import unit values to wholesale prices is alleviated. Such an improvement is likely to be brought about in part by narrowing the focus to manufactures only, which are likely to cover tradables reasonably well, and in part from the relatively less serious data problems involved. However, the use of this ratio may still be limited to developed countries and perhaps some semiadvanced countries. In addition, this ratio can be used for assessing profitability relative to selling import substitutes versus direct imports of goods only.

Ratio of import unit values to consumer prices. Owing to data problems, the CPI is likely to be used frequently as a proxy for the WPIs. Once the prices of imported goods and services are removed, the CPIs may (in principle) be used as a reasonably good proxy for the consumer prices of import substitutes.

However, the larger the number of prices of nontraded goods and services other than import substitutes, the less likely it is that the resulting ratio will be an acceptable approximation of a ratio of relative prices of import substitutes to imports. This is so because, even after the proper adjustments are made, the combination of domestic consumer prices and import prices approximates a ratio of relative prices of domestic to foreign goods and not a ratio of relative prices of import substitutes to imports.⁸⁸ Thus, if the prices of imported goods and services are not excluded from the selected CPI, this ratio is, in fact, a ratio that measures the relative price of foreign tradables to domestic tradables and non-tradables and foreign tradables. What the latter ratio is intended to measure is no longer clear.

The foregoing considerations would suggest that the calculated values may also overstate (or understate) the changes in relative prices between import substitutes and competing imports and thereby may provide misleading indications of profitability to sell import substitutes versus direct imports. The possibility of such biases should be kept in mind in interpreting the calculated values.

Ratio of import unit prices to unit labor costs. In many respects, this ratio is analogous to the ratio of import unit prices to consumer prices, except that it is expected to provide some information on the profitability of continuing to produce import substitutes rather than on international price competitiveness. In interpreting the results, however, it should be kept in mind that the calculated values are likely to overstate (or understate) the underlying developments in profitability. Also, some double counting or overlapping is likely to be involved. In this respect, a strong correlation between the two indicators is likely to considerably weaken the quality of the information that such a ratio is expected to provide.

Ratio of wholesale prices to unit labor costs. In this ratio, owing to data problems, import unit prices are proxied by wholesale prices. The potential shortcomings inherent in the price and cost indicators used have already been discussed.

This ratio is likely to be used for developed countries and some semiadvanced countries, with the subject area limited to manufactures only. Also, in interpreting the results, it should be kept in mind that the WPI may turn out to be the least satisfactory proxy for importables. Hence, unless the potential discrepancies resulting from the use of WPI as the proxy for industry selling prices of import substitutes offset those resulting from the use of unit labor costs as the proxy for producers’ costs, the calculated values are likely to overstate (or understate) the underlying changes in profitability to produce import substitutes.

Other possible indicators. The ratio of the price deflator for the imports of goods and services to the GDP deflator could be another useful indicator of profitability to produce.⁸⁹ Its purpose is to assess the cost behavior of tradables and nontradables in relation to tradables over the long run. Specifically, what it does is to measure the cost behavior of imports and import substitutes cum the nontraded goods and services in relation to imports and import substitutes.

However, for the purpose at hand, the calculated values may overstate (or understate) the actual changes in the costs of import substitutes relative to the nontraded goods and services. In addition, the results may be adversely affected by differential productivity. These considerations have to be borne in mind in interpreting the calculated values. As suggested earlier in Alternative indicators: profitability relative to domestic sales or to production, this problem could be partially solved in certain cases by adjusting the preceding ratio by a ratio of average labor productivity in the manufacturing sector to average labor productivity in the economy as a whole.

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Mr. Maciejewski, economist in the International Capital Markets Division of the Exchange and Trade Relations Department, was economist in the Consultation Practices Division when this paper was prepared. He received his doctorate from the University of Dijon and also studied at the Institute of Economic Research of the University of Hitotsubashi in Tokyo and at the Bologna Center.

The informational content of nominal effective exchange rate indices and indices of the multilateral exchange rate model (MERM) type has, however, been discussed extensively in the economic literature.

Hereinafter, termed adjusted relative price (cost) indices.

This alternative—and only correct—definition of the real effective exchange rate has been used in the economic literature (for instance, Bruno (1976)).

These are the only three instances of an effective exchange rate index discussed here, but a number of other possibilities exist, including currency baskets used in pegging certain national currencies.

As explained by Artus and McGuirk (1981, p. 275), the model is “a mathematical simulation model with emphasis on the specification of a fully consistent set of demand and supply equations for goods. Its theoretical structure is basically the Walrasian general equilibrium framework, simplified to a great extent by the use of input-output relationships.”

That is, by constraining output.

Taken into account in a consistent manner for all the industrial countries simultaneously.

Feltenstein, Goldstein, and Schadler (1979). In the suggested version, the underlying model focuses on only a few key behavioral relationships, that is, demand for money, demand for imports, determination of real expenditure, and supply of exports.

For example, an overall balance, surplus, or some specified improvement in the overall deficit recorded during a previous year or reference period.

For example, fiscal policy or tariff measures.

The process through which an equilibrium relative price is determined can be illustrated with a simple economic model, where (1) total production and total expenditure are divided into two categories—traded goods and nontraded goods and (2) constant terms of trade are assumed. The assumption of constant terms of trade helps to reduce the three-dimensional transformation function relating exportables, importables, and nontraded goods involved in the model into a two-dimensional function. Specifically, this assumption means that the three-dimensional function after trade contains a straight line in the plane relating exportables and importables. Two other key assumptions are involved—infinite mobility of resources in the production of traded versus nontraded goods, and short-term downward price and cost flexibility. The latter assumptions are of some importance in respect of adjustment process; for example, a required fall in the price of nontraded goods relative to traded goods sufficient to restore the original equilibrium relative price level may involve a considerable delay. Such a model has been used by Salter (1959) and Dornbusch (1975).

Assuming no sales taxes or factor taxes and no other distortions.

In this case, the base period should be more than a year to ensure that most of the effects of previous changes in relative prices (costs) are reflected in the selected balance of payments variable (e.g., the underlying external trade or current account).

For example, an external current account deficit, which is financed by recourse to capital inflows on a sustained basis.

The analysis of structural changes is expected, for instance, to identify and to remove the effects of policy priorities or choices on production that might have affected the external trade or current account outcome independently of relative prices (costs).

One such attempt to clarify the concepts of traded and nontraded goods in relation to the use of the most appropriate indices of relative prices was made by Goldstein and Officer (1979). The concepts of tradables and nontradables are also discussed briefly by Prachowny (1975, Chap. 2).

Or explain equally the economic behavior of each of the economic agents involved.

Also, the selected base year (or period) should not be too distant; otherwise, the calculated values may not be interpreted independently of the structural changes that occurred later.

Given the focus on international competitiveness, it is deemed that currency baskets, per se (i.e., based on the currency composition of trade), are not directly relevant for this study, owing to their narrow focus on the effects of exchange rate movements on the value of the selected variable during the base period. However, the available economic literature on the optimal peg may provide some useful insights about choosing relevant weighting procedures. (See, in particular, Williamson (1982), pp. 50 and 55.)

In this respect, some consideration should also be given to specific marketing arrangements within the reporting country (e.g., the amount of the receipts cashed by the official marketing agency may differ substantially from the amount of payments made by the same agency to producers, and lags involved in adjusting domestic producer prices to foreign prices).

If there were perfect competition and homogeneous products, the price in the importing country would reflect all the information necessary, and third-country data would be superfluous.

For example, the European Economic Community and the Organization for Economic Cooperation and Development (OECD).

For example, crude oil, petroleum products, and capital goods.

In practice, profit margins that result from contract prices in domestic currency are made to absorb some of the change in the exchange rate, as contract prices denominated in foreign currency are adjusted gradually. See Artus (1974) and Spitäller (1980).

Or closely related situations, for example, situations in which the producers in a given country are monopoly, or near-monopoly, suppliers faced with a downward-sloping world demand curve for their exported products or more specific cases, such as situations in which nonprofit-maximizing strategies (e.g., cost-plus pricing) are involved. Product differentiation is present whenever the products of individual sellers within a group that comprises a particular market are not regarded by consumers as being perfect substitutes. As a result of product differentiation, consumers may be willing to pay more for one variety of product than for another and may not be easily persuaded to change from one brand to another.

Such indices, which in theory would reflect marginal domestic costs (and sales taxes) to marginal foreign costs (and sales taxes), stand perhaps as the most readily available indices for intercountry comparisons.

However, such a statement would not apply in either case under tightly controlled external trade regimes.

This could be achieved, for instance, by cutting profit margins in foreign sales, which is an alternative action to raising prices; the question would then be how seriously profitability and investment are affected.

Such situations include those in which exports are produced and marketed against “kinked” demand curves (i.e., where price decreases do not help to increase the volume of sales much, since they are matched by other producers (inelastic demand), whereas price increases, which other competitors would not be expected to follow, will lead to declining sales).

That is, if the movements measured by the selected index do not reflect (or offset) movements in other factors that would preclude a change in market shares.

The required true export (import) price indicator is expected to be calculated on the basis of actual price and quantity data for the selected basket of goods on the assumption that “the pure export (import) price effect” can actually be isolated.

The index implicitly assumes that (1) the home country’s wholesalers and/or producers can change the prices of domestic import substitutes somewhat independently from developments in foreign prices of competing imports and (2) there is a strong demand in the home country for the products under consideration.

This is major information that indices of relative export prices cannot provide, despite improvements that they may show over time. In this respect, even for differentiated exports, it may be argued that relative cost indices are likely to be more comprehensive measures of international competitiveness than are relative price indices.

With marginal costs being appropriate for short-run analysis.

Under normal circumstances; however, see footnote 27.

The lack of proper data to help to select the most appropriate weighting system in a number of specific cases may be another problem. However, once (1) the specific set of market conditions under consideration is determined and (2) a specific policy objective or analytical question is clearly set, an appropriate weighting procedure can be chosen accordingly, and the potential loss of information is expected to be minimized.

As shown in the preceding subsections and in Appendix II, there is a reasonable presumption that different relevant or available price (cost) indices will best explain only certain categories of exports and import substitutes.

See Appendix II.

In addition, consumer prices (like wholesale prices) may include the so-called productivity bias, since they generally contain a relatively high proportion of nontradable goods (Balassa (1964)). However, there is no consensus on this issue, as other authors (e.g., Officer (1976 a)) would argue that such productivity bias does not exist.

For a detailed derivation, see Bonnie Loopesko (summer intern in Exchange and Trade Relations Department in 1980), “Derivation of an Index of Nominal Effective Exchange Rates” (mimeographed, August 15, 1980).

Allen (1975) has cogently argued for a more direct nexus between index number theory and practice, noting that the lack of good theoretical basis generally accounts for the imprecision and ambiguity of most index numbers used in practice.

However, the derivation is not based on an economic theoretical model, such as the constant utility underpinnings of price indices (although a similar model probably could be derived). Instead, a step is taken in the direction suggested by Allen (1975) by laying down precisely what the index is intended to measure and the economic logic underlying its derivation.

This question is similar to that posed by the Laspeyres index, which asks: Holding the consumption basket constant, what would be the change in the cost of purchasing the base period basket, given the change in prices from the base period?

That is, “the arithmetic average of prices of home currency in terms of partner currencies, relative to the base period, weighted by the partners’ shares in total exports of the home country.” Specifically, formulation (2) shows that the index can be rewritten so that the weights are simply bilateral export shares, that is, in the form that is generally used in calculating the effective exchange rate.

For a detailed derivation, see Anne Kenny McGuirk, “Derivation of Weights Used to Construct Indices of Competitiveness” (mimeographed, International Monetary Fund, August 1980).

In this formulation, the rightmost term represents the share of commodity i exported by country k to market j in total imports of commodity i by market j, weighted by the importance of the exports of commodity i by country x to market j in country x’s total exports to market j. The leftmost term measures the relative importance of market j in the country x’s total exports.

In this formulation, the weight W_xj is assumed to reflect the relative importance of competitor j to country x. Such a weight is measured by summing the share of country i’s import supplied by j (M_ij) over all markets i multiplied by the share of k’s exports to i (X_xi). In this formulation, M_ij denotes the importance of country j as a competitor/supplier to i, and X_xi that of country i as a market to x. This OECD specification (as well as the commodity-oriented specification presented in the next subsection) could probably be derived in a straightforward way from Armington’s (1969 a) original work on commodities differentiated by place of origin (including, in particular, Armington (1973)). Double-weighting procedures similar to the OECD formula can be improved further by incorporating the home suppliers’ effects. To do so, it would be sufficient, for instance, to replace M_i in the OECD formula by importables (M_i + $M_{i}^{d}$ ), where $M_{i}^{d}$ would represent domestically produced importables. In practice, however, this improvement may involve a major operational problem—that is, measuring for each market a subcategory of total domestic absorption that is “importable.” While this may be relatively feasible in some specific situations (e.g., exports of automobiles), it is not likely to be true for a number of other situations (e.g., at more aggregated levels of commodities).

Such as (1) the same elasticity of substitution between any two pairs of competing products; (2) relative independence and constant elasticities of substitution between the competing products; and (3) the same elasticity of substitution not only between two countries but also between two pairs of competing products.

To illustrate this point, consider Zaïre’s exports. Since copper is its major export commodity, it is obvious that exports of copper to Belgium will be little affected by the price of French exports of wine to the same market.

Since log(x) = −log(1/x), the logarithmic distance between 0 and 1 is identical to that between 1 and infinity.

That is, identification, time reversibility, circularity and factor reversibility, change of units (homogeneity), proportionality, and uniqueness in the determination of relative changes.

The degree of dependence on the base dates can be assessed by measuring the quantitative differences in the levels indicated by both the arithmetic-averaging and harmonic-averaging techniques and the geometric-averaging method. Once such a dependence is assessed and the arithmetic (harmonic) averaging technique continues to be used, it will be necessary to rebase the index frequently so that the actual weights are not allowed to diverge substantially from the weights used initially in the selected weighting procedure. It should be kept in mind, however, that this will be nothing but a technical device that does not help to improve the economic meaning of the calculated indices.

Such indices are published regularly in International Monetary Fund, International Financial Statistics (IFS) for 13 industrial countries. They are sometimes termed indices of relative prices (costs) per se.

Which cover 13 OECD countries and focus on manufactures only.

That is, productivity indices abstracting from cyclical change in output per man-hour.

Enoch (1978). See also Bank of England (1982).

According to the OECD (1978), only Japan, the Federal Republic of Germany, Sweden, Finland, and Australia publish export price series and, at that time, the United States was reportedly experimenting with the construction of similar series.

Export unit values (as well as import unit values) are not equivalent to average values, which are in fact weighted averages of quantity relatives obtained in deflating aggregate value flows by an index of aggregate volume flows. In other words, a unit value index differs from a true price index in that the raw data used as a proxy for prices are in fact average values for a basket of commodities (i.e., nominal values divided by quantities). As such, export (import) unit values measure changes in the average value of exports (imports) per physical unit and cannot help to distinguish whether the change in unit value is due to a change in price per se or to compositional shifts in the selected basket of commodities.

The major shortcomings of these indicators are (1) the fact that no “pure price effect” can be isolated, even if it is based on standard Laspeyres price formula; (2) compositional shifts and changing coverage; shifts in the commodity composition of imports and exports are generally more rapid than are shifts in patterns of consumption (relevant for the consumer price index—CPI) or production (relevant for the wholesale price index—WPI); (3) potential distortions in value data, owing to errors in invoice; (4) noncomparability in terms of the mathematical formulation used; and (5) different weights used in constructing the index. However, available data on export or import unit value indices are such that they may be used to derive corresponding indices for specific groups or subgroups of commodity aggregates. As a result, the composition, coverage, and weighting of the export or import unit value indices may be made more comparable to those of the foreign price indicator used (e.g., wholesale prices).

Like the export and import unit value indices, WPIs usually suffer from the lack of straight comparability that arises from even wider differences in the scope, coverage, methods of comparison, and mathematical formulas used. As a result, intercountry comparisons may be distorted by serious biases; for ratios of domestic relative prices (defined as the ratio of export (import) unit values over wholesale prices), the combination of two conceptually different price (cost) indicators may simply result in statistically meaningless values. This is due to incomparability in timing; wholesale prices refer to prices at the date of the sales contract, whereas export (import) unit values are calculated ex post and, thus, refer to prices at the date of shipment across borders. However, like the export and import unit value indices, subsets of WPIs may be specifically derived either for manufactured goods only or for manufactured goods and services (using the related consumer price indices). In addition, unlike export (import) unit values, wholesale prices measure changes in prices rather than average values in primary markets.

That is, whenever wholesale prices are close to being industry selling prices.

For example, indirect taxes and the need for the distribution of weights to reflect adequately each commodity export’s importance in total production.

That is, including wages, salaries, social security premiums, and other employment taxes or related expenses.

This may not necessarily be so in reality, but other more comprehensive and more representative unit cost indices are generally not yet available.

For example, the costs of raw materials, semifinished products, capital, and financing. While this is likely to be verified where exports are effected by multinational firms, there is no guarantee that such situations may be verified in most of the other cases.

There are a number of other disadvantages. Like wholesale price and consumer price indices, unit labor cost indices—including the normalized and smoothed formulations developed by the Fund—also suffer from a lack of comparability. Normalized and smoothed formulations attempt to remove the influence of cyclical swings in conventionally measured productivity so that the cyclical variations in reported employment correspond to those in labor that has actually been involved in generating the related product. In addition, the smoother version takes four-quarter moving averages so that seasonal factors and effects of other special circumstances (e.g., strikes) can be eliminated. But, unlike CPIs, indices of unit labor costs usually cover tradable goods and are more directly linked to wage developments that generally have a large influence on production costs. However, unit labor costs are likely to be available only for the manufacturing sector. Hence, actual use of such indicators is likely to be restricted to the developed countries and a number of semiadvanced developing countries.

It is well known that productivity responds quickly and markedly to cyclical changes in demand pressures, while wages tend in general to respond only gradually to such pressures and sometimes even with a relatively long delay.

The procyclical properties of profits are well known.

However, explicit measurement of such indices has become increasingly feasible and reliable in recent years.

These two indices adjusted for exchange rate movements are widely used in the Fund and the OECD. The OECD has recently developed an index of total unit current costs for the manufacturing sector as a whole using weights derived from input/output data for those countries for which data on the prices of raw materials were available (OECD, 1978, p. 44).

That is, estimated output per man-hour under conditions of “normally” full utilization of capital and labor. See Artus (1977 a).

That is, lower levels of employed production factors and capacity utilization are by definition expected to be gradually incorporated into the moving averages or trends involved in computing normalized unit labor costs.

For example, on production functions and the mean age of capital stock.

In this regard, it should be noted that CPIs cannot reflect differentiated production patterns; accordingly, should the production structures be rather labor intensive in one country and rather capital intensive in other countries, CPIs are not likely to be able to approximate factor costs reasonably well in the countries under consideration.

Unlike wholesale price indices, CPIs are heavily influenced by trends in the price of goods and services that are in the nontraded category. In addition, a number of goods and services included in such indices have virtually nonexistent demand price elasticity. Capital goods (a major component in international trade) are usually not covered, while their inclusion on account of the factor market effects involved in intercountry comparison could be required conceptually. Also, food items generally account for a relatively large share in most of the available CPIs; they may represent between 20 percent and 35 percent in developed countries and from 20 percent to more than 60 percent in developing countries. Moreover, agricultural trade is so restricted in most countries that price movements of domestically sold output usually differ substantially from international market prices. However, the lack of comparability is likely to be a less serious problem, especially in developed countries, where the sample group’s purchases tend to become more similar from one country to another and from one income group to another.

Ideally, what would be required is an index of the home country’s GDP deflator for exports of goods and/or services to the competitors’ GDP deflator but such an index is not likely to be available in most (including developed) countries.

GDP deflators may best be viewed as a composite indicator of the cost of all primary factors of production. (For an interesting analysis of GDP estimates, see Sato (1976).) GDP deflators are computed as quotients of the current and constant estimates of value added. However, such estimates may not always be factor-cost based (as they should be ideally) and thus may incorporate the effects of changes in indirect taxes and subsidies. Unlike the WPI, the GDP deflator refers only to domestically produced goods and services and is not expected to be affected by double counting. At the same time, however, the GDP deflator may not represent a final product price. For instance, GDP deflators for the manufacturing sector generally exclude the cost of intermediate inputs from all the nonmanufacturing sectors. Thus, the GDP deflator may be a less comprehensive price indicator than is the WPI.

Ideally, GDP estimates should be based on factor costs, so as to abstract from the effects of changes in indirect taxes. However, GDP deflators are often estimated in terms of market prices and thus may give rise to serious problems of comparability. Also, GDP deflators are sometimes derived from constant-factor cost series and current market price data.

This is particularly true of situations in which relative prices change rapidly and drastically or in situations that are characterized by relatively large shifts in the proportions of the factors of production utilized. In such cases, however, the use of production data may be substituted.

A difficult problem in using GDP deflators for both intercountry cost comparisons and calculations of domestic relative costs is that the differences in the calculated values may reflect differential productivity growth. In this respect, how much adjustment should be made to eliminate the resulting distorting effects is not entirely clear. Another problem with GDP deflators is that they are usually made available only after considerable delay and that they are also subject to frequent revisions.

It may be argued, on this basis, that the index could also be used as a relevant index of international price competitiveness.

This is so because export unit values tend to reflect prices at the customs post and, thus, past developments. However, the comparison of wholesale prices for exported products with export unit values may be used to study the evolution of the prices of the major export commodities relative to those of the other exports.

Unless a specific GDP deflator for nonexports of goods and services can be derived or is available.

Should the case under study involve some significant long-run changes in the capital/labor ratio, the resulting biases could be alleviated by correcting the normal output per man-hour that is used in calculating the normal unit labor costs for the effect of the changes in the capital/labor ratio. (See Artus (1977 b), P-16.)

For example, lack of uniformity across the countries under consideration.

For example, an increase in the U.S. CPIs is likely to have little effect on relative prices in Ivory Coast.

For example, the consumer prices in Saudi Arabia may have little influence on the price of the crude oil that is imported by the reporting country under study.

Such adjustments are discussed in more detail in Artus (1974). See also Spitäller (1980).

In other words, such a ratio is expected to approximate a ratio that measures the relative price of foreign tradables to domestic tradables and nontradables.

Unless a specific GDP deflator for imports of goods and services can be derived or is available.

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IMF Staff papers: Volume 30 No. 3

Author: International Monetary Fund. Research Dept.

Volume/Issue:: Volume 1983: Issue 003

Publisher:: International Monetary Fund

ISBN:: 9781451972740

ISSN:: 1020-7635

Pages:: 227

DOI:: https://doi.org/10.5089/9781451972740.024

Keywords
I. Effective Exchange Rate Indices
II. Theoretical Links Between Relative Prices, Exchange Rates, and Balance of Payments in Equilibrium
- Theoretical Underpinnings of Index of Domestic to Foreign Prices Adjusted for Exchange Rate Movements
  - Underlying PPP relationship
  - Additional problems associated with use of this index
- Theoretical Links Between Concepts of Equilibrium Prices, Exchange Rates, and Balance of Payments
III. Relative Price (Cost) Indices of International Competitiveness—Analysis and Guidelines
IV. Concluding Remarks
I. Derivation of Effective Exchange Rates, Weighting Procedures, and Operational Implications of Mathematical Formulations
II. Available Relative Price (Cost) Indices Adjusted for Exchange Rate Movements and Alternative Indicators
- Available Relative Price (cost) Indices of Export Competitiveness
- Available Relative Price (cost) Indices of Competitiveness for Import-Substituting Sector
BIBLIOGRAPHY

		Adequate
Competitors		Weighting Procedures
(a)	Domestic producers in the importing markets are the main competitors.	(a)	Trade export weights.
(b)	Other exporters selling to the same importing markets are the main competitors.	(b)	Weights that reflect the shares of other exporters in markets of interest to countries under study.
(c)	Both domestic producers and other exporters to importing markets are the main competitors; in this case, all suppliers are relevant.	(c)	Weights that reflect effectively competing shares of domestic producers and of other exporters in markets of interest to the country under study.

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Abstract

I. Effective Exchange Rate Indices

Nominal Effective Exchange Rate Indices

MERM5 Effective Exchange Rate Indices

Real Effective Exchange Rate Indices

II. Theoretical Links Between Relative Prices, Exchange Rates, and Balance of Payments in Equilibrium

Theoretical Underpinnings of Index of Domestic to Foreign Prices Adjusted for Exchange Rate Movements

Underlying PPP relationship

Additional problems associated with use of this index

Theoretical Links Between Concepts of Equilibrium Prices, Exchange Rates, and Balance of Payments

Balance of payments equilibrium and the concept of equilibrium exchange rate

The concept of equilibrium relative price11

Implications for choice of base period

III. Relative Price (Cost) Indices of International Competitiveness—Analysis and Guidelines

Framework for Analyzing Available Indices of Relative Prices (costs) and Alternative Indicators

Adequacy of Market Structures and Behavior Patterns: Relevant Weighting Procedures19

Competitive patterns in international export markets and relevant weighting procedures

Relevant weighting procedures for import-substituting sector

Specificity of What Adjusted Relative Price (cost) Indices Can Measure

Differentiated versus homogeneous products

Relevant indices of international price competitiveness

Relevant indices of profitability relative to foreign sales or purchases

Alternative indicators: profitability relative to domestic sales or to production

Available Indices: Use of Substitutes and Related Implications

IV. Concluding Remarks

I. Derivation of Effective Exchange Rates, Weighting Procedures, and Operational Implications of Mathematical Formulations

Derivation of Nominal and Real Effective Exchange Rates

Nominal effective exchange rate—derivation of index40

Nominal effective exchange rate—adjustment for inflation differentials

Weighted bilateral index of relative export prices adjusted for exchange rate changes

Weighting Procedures

Relevant weighting procedures for differentiated products

Relevant weighting procedures for homogeneous products

Intercountry Comparisons: Operational Implications of the Mathematical Formulations

II. Available Relative Price (Cost) Indices Adjusted for Exchange Rate Movements and Alternative Indicators

Available Relative Price (cost) Indices of Export Competitiveness

Existing relative price (cost) indices

Relative price indices of international price competitiveness

Cost indices of profitability relative to foreign sales

Alternative indicators: profitability relative to domestic sales or to production

Available Relative Price (cost) Indices of Competitiveness for Import-Substituting Sector

International price competitiveness

Cost indices of profitability relative to foreign purchases

Alternative indicators of profitability relative to foreign purchases or to production

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Headings

Metrics

MERM⁵ Effective Exchange Rate Indices

The concept of equilibrium relative price¹¹

Adequacy of Market Structures and Behavior Patterns: Relevant Weighting Procedures¹⁹

Nominal effective exchange rate—derivation of index⁴⁰