Constructing and using national and regional TWEXs: the case for chaining

The breakdown of the Bretton Woods system of fixed exchange rates spurred the development of trade-weighted exchange rates (TWEXs). These indexes measure changes in the average foreign exchange value of a currency over time. The construction of a TWEX index requires numerous decisions. Producers of TWEXs are revisiting many of their construction decisions because, with the advent of the single currency in Europe, all TWEXs will have to be modified. In addition, countries adopting the single currency may find it useful to develop their own TWEXs, similar to those that exist for regions within the United States. All commonly-used TWEXs are based on either a Laspeyres or Paasche price index. In the present paper we argue that producers of TWEXs should consider using the chain approach for the construction of their indexes. Our argument focuses on an issue that affects TWEXs based on either Laspeyres or Paasche price indexes -- the choice of base period. We illustrate this problem and show how it leads to different measures of exchange rate changes. A chain index, which links together the exchange rates and trade weights from year-to-year, eliminates the need for a base period.