Currency: Building Up the Trade Weighted USD Index

I know nothing about relative currency strengths historically or present day. I won't need the Vietnamese "dong" (missing accents), the Malaysian "ringgit" or the Moldovan "leu" so I'm going to stick with the US for now.
In everything I've seen, currencies are measured relative to other currencies. The dynamic goes something like this. Stipulating two countries, Country A and Country B. Country A uses the "Adollar" and Country B uses the "Bruple" as their currencies. In year 1, you can exchange 1 Adollar for 1 Bruple. Year 2, Country A raises interest rates and Country B floods into Adollars and out of Bruples to grab the excess yield. Increasing demand for Adollars (and less for Bruples) means the value of an Adollar has increased (and Bruple has decreased), which means more Bruples are needed to exchange for 1 Adollar, and the Adollar is "strong" relative to the "weak" Bruple.

Some 101 causes for strength and weakness in currencies:

1. Relatively high interest rates => relatively strong currency, relatively low interest rates => relatively weak currency.
2. Volatility in government. Leading the Failed State Index according to Wikipedia is Somalia, and the USD to Somalian Shilling exchange rate reflects the volatility involved. The graph, courtesy of FRED, says that in 2000, 20K Shillings bought $1 and in 2010, that number jumped to 32K Shillings buying $1. Note that this is a ratio of x/y. Increasing x can produce the same ratio as decreasing y. In the case of shillings/dollar, we know that the dollar is relatively stable in comparison to the shilling, because, you know, Somalia isn't a vacation home. In other cases, this could be a bit more convoluted when dealing with more stable governments (such as British pounds/dollars).
   
   
3. Relevant today is inflationary policy from the central banks. Buzzword of 2013 "Abenomics" and the BoJ has devalued the yen significantly with more aggressive inflationary policies than the Fed. Even if both are inflating their currency, more aggressive inflation will make it a relatively weaker currency.

The recurring word is relative. Currencies are measured against a benchmark. That can be another countries currency or the same currency at a specific point in time (how many 2000 dollars would buy a 1980 dollar).

The question then becomes choosing a relevant benchmark for comparison. One of those benchmarks is the Trade Weighted USD Index (also known as the "broad index". The idea is to aggregate values of many different currencies to get a broad (index) view of how the buck is doing in comparison to a basket of other currencies. The basket is weighted according to trade data, which I take to mean that currencies are weighted based on how relevant they are to US trading globally, so the euro, yuan, pound and yen take up most of the index weight compared to the Swiss franc or Vietnamese dong (if even included). This means that movements in the euro, yuan, pound and yen will more heavily affect the index calculation than the dong and franc.

Here's the broad index in action, again, from FRED:

The USD was relatively strong compared to the currency basket of the Broad Index from '97 to '08 (being above 100). The recessionary period from '08-~10 is an example of the relative nature of currency measurement (at least, in the Broad Index form). Although the US was in recession, so was everyone else. In global uncertainty, being in USD makes more sense than being in less stable currencies because there's a pretty strong expectation of the dollar being around tomorrow and that it won't be allowed to be destructively volatile. Another interesting implication comes from the deductive nature of economics (this leads to that which leads to something else which affects blank). Currency devalues. When a currency devalues against a second currency, that second currency can buy more of the first currency. Demand rises which strengthens the devalued currency, and the circle completes. 

As far as the calculation goes, the Broad Index is a geometric mean that multiplies together weighted period-to-period changes in single currencies. The result is then multiplied by the index value at the last calculation (ie, t-1 for period t) to get a new index value. A variation on the TWEXB adjusts for real exchange rates. Whenever "real" is involved, inflation is factored in. The TWEXB based on real exchange rate includes a ratio of the basket currency CPI to the US CPI at the periods t and t-1, which affects the period-to-period changes in single currencies. Blah.

Next time, I'll look at USD against a bunch of currencies individually.