Value-Added Exchange Rates

This paper updates the conceptual foundations for measuring real effective exchange rates (REERs) to allow for vertical specialization in trade. We derive a value-added REER describing how demand for the value added that a country produces changes as the price of its value added changes relative to competitors. We then compute this index for 42 countries from 1970-2009 using trade measured in value added terms and GDP deflators. There are substantial differences between value-added and conventional REERs. For example, China's value-added REER appreciated by 20 percentage points more than the conventional REER from 2000-2009. These differences are driven mainly by the theory-motivated shift in prices used to construct the value-added REER, not changes in bilateral weights.