Bilateral and multilateral exchange rate and purchasing power parity indexes: the aggregation problem

Following the high variability of floating exchange rates after the collapse of the Bretton-Wood System, policymakers have increasingly relied on weighted exchange rate indexes (nominal effective exchange rate index) or indexes of competitiveness (real effective exchange rate or purchasing-power-parity index)in order to assess the need for and the magnitude of exchange rate adjustments.However, these indexes are plagued by many methodological problems that impinge on their reliability. This paper is concerned only with one of the main limitations of these indexes, namely, the ad-hoc character of the determination of the weighting system used in their construction. To solve this problem, a new kind of index is proposed, which is derived from a complete system of export demand functions endowed with aggregative properties. This new index is compared with the effective exchange rate index (MERM) of the International Monetary Fund.