The nominal effective exchange rate (NEER) and the real effective exchange rate (REER) are both indicators of a nation’s competitiveness in relation to its trading partners.
What Is the Real Effective Exchange Rate (REER)?
The real effective exchange rate is a measure of the relative strength of a nation’s currency in comparison with those of the nations it trades with. It is used to judge whether the nation’s currency is undervalued or overvalued or, ideally, fairly valued.
In other words, the real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against that of each country in the index.
An increase in a nation’s REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper. It is losing its trade competitiveness.
Example of Real Effective Exchange Rate (REER)
1.Let’s say the U.S. had a foreign trading relationship with only three parties: the eurozone, Great Britain, and Australia. That means the U.S. dollar has a trading relationship with the euro, the British pound, and the Australian dollar.
2. In this hypothetical example, the U.S. does 70% of its trading with the eurozone, 20% with Great Britain, and 10% with Australia. The basket of currencies in this case would also hold the same percentages, with the euro at 70%, the British pound at 20%, and the Australian dollar at 20%.
3. A move in the euro would have a greater impact on the basket than a move in the Australian dollar. If one of the exchange rates moved significantly but the weighted average of the basket didn’t change, it could mean that the other currencies moved in the opposite direction, offsetting the move of the first currency.
What Does a High REER Mean?
An increase in a nation’s REER means businesses and consumers have to pay more for the products they export, while their own people are paying less for the products that it imports. It is losing its trade competitiveness.
Limitations of the Real Effective Exchange Rate (REER)
1. The real effective exchange rate doesn’t take into account price changes, tariffs, or other factors that may affect trade between nations. If prices are higher in one country compared with another, trade might decrease in the country with higher prices, impacting its REER.
2. In addition, the central bank of each nation adjusts its monetary policy, which can lower or raise interest rates in the home country. The flow of money could increase to the countries with higher rates as investors chase yield, thus strengthening the currency exchange rate. The REER would be impacted, but it would have little to do with trade and more to do with the interest rate markets.
The nominal effective exchange rate (NEER)
NEER is the average rate at which one nation’s currency is valued in comparison with a basket of other currencies, weighted for the percentage of trade that each currency represents to that nation.
The NEER can be adjusted to compensate for the inflation rate in the home country. That adjusted number is the REER.
The Reserve Bank of India (RBI) has been constructing five-country and thirty six-country indices of NEER and REER as part of its communication policy and to aid researchers and analysts.