An exchange rate index (ERI), also termed an effective exchange rate, is an overall measure of the exchange rate of a currency when measured against multiple other currencies. This is in contrast to a bilateral exchange rate, which is the rate of one currency against one other currency. An ERI is usually calculated as a weighted geometric average of the bilateral exchange rates used in the index and expressed in an index form relative to a reference period, for example, Jan 2005 = 100. The choice of currencies in the index and their associated weights is usually determined according to the relative importance of the economy’s trade flows with other countries. These choices can be revised over time to allow for changing patterns of trade.
Until the early 1970s, the Bretton Woods post-war system of fixed exchange rates meant that the dollar exchange rate of any currency would serve as a reliable measure of its level. The dollar could in turn be regarded as fixed in terms of the $35/oz. official price of gold. But since that time, with floating exchange rates, using any one bilateral rate for a currency would give a possibly misleading indication of its overall level against other currencies.
The practical steps involved in determining the basket of exchange rates and their associated weights for use in an ERI can be surprisingly complicated. Firstly, it requires a choice of economic framework, such as international trade competitiveness, to determine which trade data should be used; secondly, the required data demands can be considerable, depending on the method chosen, and there may be known statistical issues, such as incompleteness, inconsistency or poor timeliness in the actual trade data which will require dealing with.
Other practical considerations include: how many currencies to include in the ERI basket; how frequently to revise the weights; and how to revise existing data series when revised weights or new methods are adopted. For these reasons, international institutions such as the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) have mainly taken the lead in developing methodologies for exchange rate indices. But it should be noted that there is no official international standard governing the calculation of ERIs.
The methods developed by the IMF and BIS take account not only of an economy’s bilateral exports and imports trade flows, but also of its competitiveness against all other economies in all world markets. Implementing these methods can require considerable data demands. These are described at: T Bayoumi, J Lee and S Jayanthi 'New Rates from New Weights', IMF Working Paper WP/05/99, 1999 and M Klau and S Fung, “The new BIS effective exchange rate indices”, BIS Quarterly Review, March 2006, pp 51–65.
In addition, many national central banks calculate an exchange rate index for their own currency, usually following a similar method to those of the IMF or BIS. The Bank of England has published ERI measures both for sterling and for other major currencies.