2 Framework
Figure 1 presents New Zealand's real trade-weighted index (TWI) over time. Notably, the real exchange rate has fluctuated around a relatively stable mean over this 40 year period. The post-1985 average (the period over which the dollar has been freely floating) is only slightly above the average in the preceding 15 year period. The peaks and troughs of the cycles have not differed greatly, despite the wide range of exchange rate regimes, the two exceptions being the time of the 20% devaluation in 1984 and the early 2000s. The post-2003 period is the longest episode of the real exchange rate being above its long-run average.
- Figure 1: New Zealand’s real trade-weighted exchange rate
- Figure 2: New Zealand’s real and nominal trade-weighted exchange rate
- Source: Reserve Bank of New Zealand
Since the floating of the dollar in 1985, the real exchange rate has closely followed the nominal exchange rate. This is because of both New Zealand's and New Zealand's trading partners' generally low rates of inflation (figure 2). More weight will be given to the real exchange rate in the evidence section of this paper for the sake of international comparisons. In addition, the real exchange rate provides a better measure of international competitiveness, particularly when countries experience variable price levels. Box 1 sets out some of the common exchange rate definitions.
It is useful to discuss the behaviour of exchange rates over three time horizons. Distinguishing between them is important as they all have different characteristics, drivers and implications for the economy and policy. Figure 3 presents a stylised path for the real exchange rate that helps frame some of the issues:
- Long-run level - reflecting some notion of the average or equilibrium real exchange rate;
- Medium-term cycles or swings - reflecting deviations from the long-run level of the real exchange rate. These medium-term cycles are referred to as exchange rate variability and they are seen over a multi-year horizon; and
- Short-term volatility (not plotted) - largely reflecting fluctuations in the nominal exchange rate at say day-to-day or month-to-month, up to a one-year horizon that see the real exchange rate move around the cyclical real exchange rate. In figure 3 these would be plotted as fluctuations around the blue line.
- Figure 3: Stylised path for the real exchange rate
- Source: The Treasury
Box 1: Definitions
Nominal exchange rate: The nominal exchange rate specifies how much one currency is worth in terms of another. It is the value of the home nation’s currency in terms of a foreign nation’s currency. For example, the average for November 2010 was for one New Zealand dollar to buy around 0.78 Australian dollars.
NZD/AUD: New Zealand dollar/Australian dollar cross rate
NZD/EUR: New Zealand dollar/euro cross rate
NZD/GBP: New Zealand dollar/British pound cross rate
NZD/JPY: New Zealand dollar/Japanese yen cross rate
NZD/USD: New Zealand dollar/US dollar cross rate
Real exchange rate: The real exchange rate differs from the nominal exchange rate because it is adjusted for the domestic price level relative to the foreign price level.
Effective exchange rate: A measure of one economy's currency against a basket of foreign currencies. Different weights apply to different economies and the weights are often based on trade patterns. The effective exchange rate can be calculated in nominal and real terms.
Trade-weighted index (TWI): This is an example of an effective exchange rate. It is a measure of movements in the New Zealand dollar against the currencies of New Zealand's major trading partners. The commonly cited measure of the TWI* comprises the US dollar, Australian dollar, the Japanese yen, the euro and the British pound.
* The RBNZ also publishes a broader measure of the TWI. See Kite (2007) for more details.
