A reassessment of measures of the dollar's effective exchange value

Recent attention has focused on measures of the dollar's effective exchange rate amid disappointment by some observers with the response of the U.S. trade balance to the depreciation of the dollar since February 1985. In particular, these observers suggest that the traditional indexes, which include only currencies of industrial countries, overstate the dollar's decline because it has depreciated much less against the currencies of some key newly industrialized trading partners. ; This paper begins with a description of the uses of effective exchange-rate indexes and describes theoretically the choice of an index, which varies with the application. Although the inclusion of currencies of developing countries in an index may be useful for analyzing trade developments, it is not appropriate for some other purposes, such as providing information for monetary conditions. The latter part of the paper focuses on measures of exchange rates suitable for analyzing trade flows and domestic inflation and compares their performance in the context of the equations used by the Federal Reserve Board staff to forecast trade components and price deflators for exports and imports. The results suggest that the addition of the currencies of important developing-country trading partners in an index of exchange rates improves its performance in forecasting export volume and import prices but makes little difference for the forecasts of export prices.