Nominal Effective Exchange Rate

Updated on January 31, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Nominal Effective Exchange Rate (NEER)?

The nominal effective exchange rate, or NEER, measures a currency’s value against the weighted average of multiple foreign currencies. It indicates a country’s competitiveness in the foreign exchange or forex market. Forex traders also call it the trade-weighted currency index.

Nominal Effective Exchange Rate

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One may adjust NEER to account for a country’s inflation rates relative to other nations’ inflation. The metric ascertained following the adjustment is the real effective exchange rate or REER. NEER surges if a nation’s currency surges relative to a group of other currencies in a floating exchange rate regime. In contrast, the former drops if the latter decreases.

Key Takeaways

  • NEER measures a domestic currency’s nominal exchange rate relative to a group comprising various foreign currencies by utilizing unadjusted weighted-average computation. Sometimes, experts call it the trade-weighted currency index.
  • The nominal effective exchange rate formula includes the geometric average of exchange rates in a selection of ‘n’ currencies.
  • A noteworthy difference between NEER and REER is that the former may not provide an accurate measurement due to the inflation differential.
  • Currency arbitrageurs in the foreign exchange markets often use NEER to make profits. Moreover, experts use this measure to conduct policy analysis concerning international trade.

Nominal Effective Exchange Rate Explained

The nominal effective exchange rate is a weighted average exchange rate indicating the nominal value of a nation’s currency relative to a group of other currencies. The nominal exchange rate is the amount of local currency necessary to purchase foreign currency. NEER measures a country’s ability to compete globally in the forex market.

One must remember It only expresses relative value and does not definitively indicate if a currency is strong or becoming strong in real terms. Instead, it represents a currency’s strength or weakness relative to other currencies. Moreover, NEER indicates if a currency is weakening or strengthening compared to foreign currencies.

A NEER coefficient over 1.0 indicates that the domestic currency’s worth is relatively more than the imported currencies. In contrast, when the coefficient is less than 1.0, it is a sign that the former’s worth is relatively less than the latter.

Economists utilize NEER to analyze policies concerning international trade. Also, traders carrying out currency arbitrage utilize this concept to fulfill their objectives.

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Formula

The nominal effective exchange rate formula is as follows:

nominal effective exchange rate formula

Where:

  • Si = The indexed currency’s exchange rate against the country’s currency
  • S*I = The indexed currency’s exchange rate against the country’s exchange rate during the base period
  • n = The total number of currencies in the group or basket
  • Wi = The currency’s weight in the basket

As one can observe from the above equation, the nominal effective exchange rate calculation involves using the geometric average of the exchange rates in a group comprising n currencies. As with every exchange rate, the NEER can help determine if currencies store value more or less effectively.

Example

Let us look at this nominal effective exchange rate example to understand the concept better.

Tan Sri Nor Shamsiah Mohd Yunus, the governor of Bank Negara Malaysia or BNM. According to her, the strong US dollar owing to the Fed’s aggressive tightening of the monetary policy, is one of the main reasons behind the depreciation in the ringgit’s value. Moreover, she said that the downtrend was per the regional and major currencies, which does not signify that the Malaysian economy is in a crisis.

The ringgit depreciated by 11.2% against the US dollar, which was in line with the regional trends. That said, the currency’s NEER recorded a significantly smaller depreciation of 2%. Nor Shamsiah expects the US dollar’s strength to persist owing to the US monetary policy’s projected path and the ongoing global risks. However, she believes that once the external uncertainties subside, Malaysia’s currency will adjust to reflect the economy’s underlying fundamentals.

Nominal Effective Exchange Rate vs Real Effective Exchange Rate

Besides looking at a nominal effective exchange rate example, one needs to learn how NEER and real effective exchange rate or REER differ. Knowing the distinct vital characteristics is crucial to understand these two concepts clearly. Moreover, individuals can avoid confusion by becoming aware of the crucial differences. So, let us look at their distinct characteristics in detail.

NEERREER
NEER reflects a domestic currency’s relative value against other foreign currencies.   REER reflects a nation’s inflation-adjusted value relative to other major currencies.
NEER does not provide accurate measurements owing to the inflation differential.Economists consider the real effective exchange rate a more accurate measure as it is an inflation-adjusted measure. 
The nominal effective exchange rate calculation involves the nominal parts. Hence, it does not consider the difference in purchasing power between the two currencies. REER includes trends and price differences.   
Individuals measure NEER against a selection of foreign currencies. One computes REER based on NEER.

Frequently Asked Questions (FAQs)

1. How do you find the nominal effective exchange rate?

NEER is the weighted average of a national currency’s bilateral nominal exchange rates against other foreign currencies.

2. Why REER is better measure than nominal effective exchange rate?

The real effective exchange rate, or REER, is the nominal effective exchange rate adjusted by the inflation differentials between the national and the trading partners’ currencies. Hence, contrary to NEER, REER indicates a domestic currency’s real strength relative to a selection of currencies.

3. What happens if nominal effective exchange rate increases?

An increase in NEER indicates an appreciation in the domestic currency’s value relative to multiple foreign currencies.

4. Why is nominal effective exchange rate important?

An increase or decrease in NEER indicates an appreciation or depreciation of a country’s currency relative to its trading partners’ weighted basket of currencies. Thus, NEER indicates the strength and competitiveness of a country’s currency within the foreign exchange or forex market. Economists use this measure to analyze policies related to international trade. Moreover, this concept is used by individuals engaging in currency arbitrage in the forex market.

This article has been a guide to what Is Nominal Effective Exchange Rate. We explain its formula, example, and differences with the real effective exchange rate. You may also find some useful articles here –

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