RDP 9005: Real Exchange Rates and Australian Export Competitiveness 1. Introduction

The exchange rate between the Australian dollar and other currencies is an important relative price in the Australian economy. The exchange rate is a key factor in the level of competitiveness of Australian industry, and can have a significant impact on Australia's trade flows. Given the large current account deficits of Australia in the 1980s, the exchange rate is particularly important in addressing our external imbalance.

The Australian dollar exchange rate is often quoted in the media as a nominal exchange rate with another currency such as the US dollar or Japanese Yen. Although bilateral exchange rates arc important in determining trade flows between countries, they give little information about the overall competitive position. Nominal bilateral exchange rates make no allowance for inflation differentials, and ignore the third country effects of independent changes in the exchange rates of other countries. A summary index which incorporates a number of real bilateral exchange rates can be used to give a more accurate indication of competitiveness.

Existing measures of Australia's real exchange rate are either unavailable over a long period, have a narrow coverage, have inconsistencies in their calculation, or are not based on recent trade data. The object of this paper is to address the shortcomings of available indices by developing a long run and consistent external measure of the real exchange rate, based on Australian export competitiveness. Since there are several conceptual problems in defining and measuring real exchange rates, we briefly consider some of the concepts behind the construction of a real exchange rate index. We also discuss a number of methodological issues relating to the construction of exchange rate indices.

This paper develops several quarterly measures of the real exchange rate for the period 1960 to 1989. The indices are calculated as geometric weighted averages of bilateral real exchange rates, where the real exchange rates are estimated using the CPI as the price deflator. Several different bilateral and third country based export weights are used. The merits of other exchange rate indices are discussed and compared. Particular attention is given to the behaviour of the various exchange rate indices in the period since the float of the Australian dollar in December 1983. The paper concludes with a brief summary.