The Trade Weighted Index

The trade weighted index is thought of as the standard by which the value of a nation is measured while trading with other trading partners. The index is a measure that doesn't have any fixed units. Based on the weights of the US dollar and the given foreign currency, the units of the Australian dollar per dollar, the units of the given foreign currency, the weights of the US dollar and the given foreign currency, the currency period, and the number of currencies included in the Trade weighted Index are used to calculate it. The changes in the TWI over time is seen based on the causative factors, mainly including the changing formula over time, the changes in exchange rates and inflation across the partners. Currently, 90% of Australian trading is tied to TWI. This makes TWI very crucial in the Australian economy with respect to her trading partners.
Definition of Trade Weighted Index
It is a measure of the value of a country's currency against that of their trading partner countries' currencies. It is expressed in index value form and its importance is dependent on the percentage of trade done with that country. It is often used to indicate a country's performance making it very useful for measuring the currency's international performance (Tejvan Pettinger, 2013). This is used also in identifying whether a country's domestic production is showing a progress through better corporate performance over time, as compared to the trading partners (Golbdberg, 2004). This is mainly used in ensuring better industry performance over time to a country, in improving the net Gross Domestic Product (GDP) as compared to others.
Reasons for Using Trade Weighted Index
The exchange rate plays a very important role when it comes to the trading sector of the Australian economy. The changes found in various exchange rates have effects on the supply and demand of the export and imports and on the price at which goods are transacted. The fluctuation of the exchange rate is therefore a very important part in analyzing the economy (Berument and Pasagullari, 2003). The changes in the real exchange rate across time between Australia and its trading partners is seen to be of great importance. This is mainly seen through appreciation and depreciation within the currencies used for trading (Hannah Kite, 2007). When there appears to be depreciation to the Australian currency with respect to the importers of her commodities, these countries purchase Australian goods cheaply as Australia imports her production goods more expensively. This is seen to reduce Australian firms' profits at any given time. If the Australian exchange rates appreciates with respect to time, the vice versa occurs. Australian goods increase in value as compared to those of the trading partners. This makes her make cheap imports and sell exports at higher rates. This consequentially is an advantage to the Australian firms as they make more returns in terms of profit from the trade (Ahmed, 2003). Weighted Trade Index is used in the calculation of the index, giving Australia an advantage over the other countries or a disadvantage in respect to her trading partners. This makes TWI a very important measure in trade for any country in the world (Bruce White, 1997).
The exchange rate position requires to be summarized; such summaries are known as the trade weighted index. To construct a TWI many things are needed and they differ from country to country. The number of currencies has to be decided. Weights are used to capture the changes in the external sector competitiveness. This is the competition that the suppliers face when competing in the export markets (Hannah Kite, 2007).
The Trade weighted indexes are considered to provide a way of measuring the effect of fluctuating prices for imports and exports and how they influence the consumer prices. The measure of fluctuation by a country gives room for the solutions emanating from the identified problems seen from the calculations. Whenever fluctuation is in terms of appreciation on one country against another, there is gains on the appreciated exchange rate country against the other. When it happens otherwise with the home country experiencing a depreciation in terms of the fluctuation, there is need to balance the losses that follow a decline (Bruce White, 1997). The solutions are often derived from Trade Weighted Index with the main aim of stabilizing the returns of a country against the other trading partners, such us use of a standardized currency, to insure the trading partners against any foreseen risks that may occur.
Calculation of TWI in Australia
The method used to construct the Australian trade-weighted index has changed a number of times over the years; this has caused changes to reflect on the formula and the weights used. The base time frame for the TWI is May 1970 = 100. Weights are refreshed yearly, with the TWI grafted together at each period in which the weights change.
The formula used for calculating TWI is shown below:
Calculating of the TWI:
Example:
We are going to use five currencies as an example of how the TWI is calculated.
Currency Trade Weight Exchange rate- foreign currencies per AUD
Current period Base period
USD 0.2152 0.6910 0.5923
EUR 0.0598 1.1720 1.0822
JPY 0.2484 80.4348 86.82
GBP 0.0988 0.4216 0.3697
NZD 0.3780 0.9013 0.8211






Applying the formula:

= 67.57
*This scale factor was set at 76.6581 (Reserve bank of New Zealand, 2017)
Calculated Weights
The calculated weights (TWI=67.57%) indicated Australia's share within each of the trading partners, on the exports plus imports, termed as total merchandise for the country.
In the past, the 22 countries trading with Australia had their currencies included in TWI's calculations, though some of the countries showed comparatively lower trade shares given to them. The calculations on the TWI=67.57% reflect almost the 100% of Australian's total merchandize in place, within the period in which the calculations have been made.
Reasons of the Changes in TWI with Time
The method of constructing the Trade weighted index has changed many times over its history. These involve changes to the weight and the formula used to calculate it. TWI came up in 1974 when Australian dollar value would be pegged to other currencies. The base period was then selected to be 1970. Also, the strategy for ascertaining the weights was changed to some degree. Before 1988 the weight of countries that had small trade shares was added to that of a bigger trading partner with which they could be grouped.
Between 170-1988, weighted arithmetic mean was used, in 1988-2011, weighted geometric mean was employed.
From 2011 till present, weighted geometric mean is still used in the calculations.
From May 1970 across all the periods, the base period is always equivalent to 100 with minimal changes seen throughout the periods. In 1970-1988, there was 100% of the merchandise trade involved, with given small trading partners, with the given trade weights to the specific trading partners, with their currencies mainly used as the weights in this context (Ahmed, S., 2003).
In 1980-2011, there are at least the 90% of the merchandize trade, with the given specific trading partners, with the exclusion of the currencies.
In 2011 to present, there is at least 90% of the total trade, from the specific smaller trading blocs or partners, with the exclusion of the currencies in the trade. This makes currency fluctuations not a great challenge to the traders.
The weights are calculated annually in order to capture the changes in trade shares, although the changes in the weights tend to be small. Occasionally this causes changes in the composition the basket. The calculation changes usually happens in September, with the new index spliced onto the existing TWI (Reserve bank of Australia Bulletin, 2002).
Currently Used Weights and their Compositions In Australia
New weights of the Australian dollar apply from 1st December 2015; this is according to a study conducted by the Reserve Bank in Australia. They are founded on the composition of Australia's merchandise goods and services for the year 2014/2015. The Philippine Peso is not included anymore causing a slight change in the composition of the index. The index itself is the weighted sum of the exchange rate logarithms.
The countries associated with the currencies shown below have accounted for 90% of Australia's trade for the year 2014/15. The change in the weights increased/decreased with about a 1 percentage point for example the US dollar increased buy one percent and the Chinese renminbi decreased by one percentage point.
These weights are used in the policy formulation of countries trading alongside Australia in terms of exports or imports.
The table below shows the weights that are currently used:
Weights in the Trade-Weighted Index
Currency Weight
From 1 December 2015 1 Dec to 30 Nov 2015
Chinese renminbi 26.7150 27.8725
Japanese yen 11.8869 12.5093
United States dollar 10.8137 9.7650
European euro 9.2587 9.2279
South Korean won 6.0400 5.9646
Singapore dollar 5.0235 5.1525
New Zealand dollar 4.1418 3.9440
United Kingdom pound sterling 3.7134 3.5313

Release date: 30 November 2015
(Reserve bank of Australia, 2015)
Conclusion
In this paper we have shown the current way of calculating the TWI. We noted that the TWI is used to capture the competitiveness of the external sector. We gave a summary of all the weights currently used in Australia. The example used to calculate the TWI was a five currency index, however, the currencies are expanded to a border range of currencies that the bank also began expanding to in calculating and publishing. It can also be seen that the TWI helps in assessing the profitability of the firms in Australian firms. This is because it helps assess the effects of the real exchange rates with the production sectors of the economy at any given time. Berument and Pasagullari (2003) and Ahmed (2003) from their findings in calculation of TWI indicate its implication on overall economic performance of Turkey and Latin America, as can be seen in the case of Australia. This leads to the observation of whether the depreciation or appreciation observed is asymmetric or symmetric. This when found to be asymmetric for example, it tells that an increase in industry specific levels of competitiveness from the depreciation seen does not impact the increase in output levels from the weighted exports.

References
Tejvan Pettinger, 2013, Trade weighted index. [Online] Available at: [Accessed Sept.23, 2017].
Bruce White, 1997, Trade weighted index (TWI) a measure of the effective exchange rate. [Online] Available at: [Accessed Sept.24, 2017].
TWI - Method of Calculation, [Online] Available at: [Accessed Sept.24, 2017].
Hannah Kite 2007, A review of the trade weighted exchange rate index, [Online] Available at: [Accessed Sept.26, 2017].
Ahmed, S. 2003. Sources of economic fluctuations in Latin America and implications for choice of exchange rate regimes. Journal of Development Economics, 72, 181- 202.
Berument, H., and Pasaogullari, M. 2003. Effects of the Real Exchange Rate on Output and Inflation: Evidence from Turkey. The Developing Economies, 41, 401-435.
Goldberg, L. S. 2004. Industry-Specific Exchange Rates for the United States, Economic Policy Review, 10, 1-16.