Optimal Currency Basket Estimation

Etienne Vaccaro-Grange

No 2026/131, IMF Working Papers from International Monetary Fund

Abstract: Small open economies often anchor their exchange rate to a basket of foreign currencies, with weights typically set from trade shares or financial exposure. Such schemes ignore the heterogeneity of pass-through across currencies and the covariance structure of bilateral rates, and therefore do not minimize the volatility of imported inflation, the central bank’s mandate. This paper proposes a minimum-variance framework — formally analogous to a Markowitz portfolio problem in pass-through space — in which basket weights minimize the variance of exchange-rate-driven imported inflation, subject to a constraint that preserves the basket’s cumulative pass-through. Applied to the case of Fiji, an import-intensive island economy with a five-currency basket, the optimization reduces the variance of imported inflation by close to twenty percent, with results robust across alternative specifications.

Keywords: currency basket; exchange rate pass-through; minimum-variance portfolio; small open economies; monetary policy; IMF working papers; inflation pass-through; pass-through space; heterogeneity of pass-through; basket weight; consumer price index; Currencies; Inflation; Exchange rates; Import prices; Pacific Islands (search for similar items in EconPapers)
Pages: 23
Date: 2026-07-03
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