What is the Trade-Weighted Dollar?

The trade-weighted dollar is an index created by the FED to measure the value of the USD, based on its competitiveness versus trading partners.

Key Takeaways

  • The trade-weighted dollar is an index created by the FED to measure the value of the USD, based on its competitiveness versus trading partners.
  • A trade-weighted dollar is a measurement of the foreign exchange value of the U.S. dollar compared against certain foreign currencies.
  • The trade-weighted dollar is used to determine the U.S. dollar purchasing value, and to summarize the effects of dollar appreciation and depreciation against foreign currencies

Understanding Trade-Weighted Dollar

The trade-weighted dollar is used to determine the U.S. dollar purchasing value, as well as to summarize the effects of dollar appreciation and depreciation against foreign currencies. When the value of the dollar increases, imports to the U.S. become less expensive, while exports to other countries become more expensive.

A trade-weighted dollar is a measurement of the foreign exchange value of the U.S. dollar compared against certain foreign currencies. Trade-weighted dollars give importance, or weight, to currencies most widely used in international trade, rather than comparing the value of the U.S. dollar to all foreign currencies. Since the currencies are weighted differently, changes in each currency will have a unique effect on the trade-weighted dollar and corresponding indexes.

There are two primary indices that are used to measure the strength of the USD. The first is the U.S. Dollar Index, created in 1973. It is composed of a basket of six currencies—euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. The euro is, by far, the largest component of the index, making up almost 58 percent (officially 57.6%) of the basket. The weights of the rest of the currencies in the index are—JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), CHF (3.6%). During the 21st century, the index has reached a high of 121 during the tech boom and a low of 71 just prior to the Great Recession.

The second is the Trade Weighted Dollar Index, sometimes called the Broad Index. This index was introduced by the U.S. Federal Reserve Board in 1998 in response to the implementation of the euro (which replaced many of the foreign currencies that were previously used in an earlier version of this index) and to more accurately reflect current U.S. trade patterns. The Federal Reserve selected 26 currencies to use in the broad index, anticipating the adoption of the euro by eleven countries of the European Union (EU). When the broad index was introduced, U.S. trade with the 26 represented economies accounted for over 90% of the total U.S. imports and exports.

During the financial crisis, both indices rose sharply during the Great Recession as investors flocked to the U.S. dollar, which is the de facto safe haven when the whole world is in turmoil.