Real Effective Exchange Rate

Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

Real Effective Exchange Rate (REER) Definition

The Real Effective Exchange Rate (REER) refers to the aggregate average of a currency compared to an index of other currencies or a group of major currencies. It indicates the import and export competitiveness of a country. REER is expressed as an index number.

Real Effective Exchange Rate

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REER is an essential indicator; It defines a country’s trade competitiveness depending upon the weightage it holds in front of a basket of currencies. Alternatively, this could be an index comprising the exchange rates of other countries. A high REER is a bad sign for a domestic currency. It implies that said economy is losing its trade competitiveness.

Key Takeaways

  • The Real Effective Exchange Rate (REER) determines the weighted average of a particular currency compared to a basket of other major world currencies. It also indicates a country’s economic performance and trade balance.
  • IMF, Real Effective Exchange Rate, and BIS are closely interlinked. That is, all important monetary policies regulated by the world bank, IMF, and BIS are directly or indirectly based on REER.
  • The Nominal Effective Exchange Rate and Real Effective Exchange Rate of a country’s currency differ from each other. REER is adjusted for inflation, but NEER is not. REER is analyzed more critically than NEER.

Real Effective Exchange Rate Explained

The Real Effective Exchange Rate (REER) is a performance measure for currencies. One currency is compared to a basket of foreign currencies; the metric determines ups and downs pertaining to trade competitiveness.

The basket of currencies is generally expressed in the form of the Real Effective Exchange Rate index. REER is like a comparative ratio that compares currencies based on the increase and decrease in currency’s purchasing power.

A nominal effective exchange rate (NEER) is derived by comparing the domestic currencies’ value with the weighted average of other major currencies. At the same time, REER is calculated by adjusting the NEER based on price indices and other aspects. In simple terms, it can be said that REER is NEER minus inflation level, labor cost, and other influencing factors.

REER is an important concept for financial authorities like the world bank, BIS, and IMF; they use the metric to understand the growth of a country. REER also indicates problems faced by a particular nation owing to currency’s low value and low purchasing power in the global market. For example, the IMF uses the consumer price index to determine REER. A Consumer Price Index (CPI) measures the fluctuation in the prices of goods and services in a basket.

Consumer Price Index(CPI)

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A market basket comprises a varied set of goods and services that most households use, and the change in the prices of which directly affects an economy every year.

REER can be obtained by different methods, but its purpose is to describe the currency’s equilibrium. The Real Effective Exchange Rate data is an important factor in scaling the economy.

For example, if the US dollar exchange rate declines against China, US exports to China will become inexpensive and considerably cheaper because Chinese consumers buying US products have exchanged their currency for US dollars to purchase the exports. If the dollar is weaker than the Chinese currency, It would mean that Chinese people will have an advantage. They are getting more dollars for each currency note; this will ultimately make US goods cheaper because of the decline realized between China and US’s exchange rate. The index between two currencies plays an important role in determining the exchange rate.

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REER Formula

The REER formula is as follows:

REER = CERn x CERn x CERn x 100

Here, CER represents the country’s exchange rate.

The Step-by-step calculation process is as follows.

  • The exchange rate average is calculated after designating the weightage of each rate.
  • For example, if a currency has a 40% weightage, the exponential power of the exchange rate is raised to 0.40.
  • Similarly, a weightage is allotted to each exchange rate.
  • Then, the formula is applied to multiply all the exchange rates.
  • Finally, the outcome is multiplied by 100 to link it to an index.

REER Example

Let us look at an example to understand REER better.

In 2018, the Sri Lankan rupee declined to a record low of 158.90 per dollar. The terrible low broke its previous record of 158.80 and ended at 158.85/10 per dollar. It was speculated that banks were interested in buying dollars, but sellers were not available—this put substantial pressure on the currency—the central bank opted for a gradual depreciation.

The dealers expected the Sri Lankan rupee to vary between 162-163 by the end of 2018. However, gross external reserves were at $9.1 billion, and REER suggested currency was still competitive.

Consequently, foreign investors exited—selling government securities worth 787 million Sri Lankan rupees ($4.96 million) and bringing the outflow to 17 billion Sri Lankan rupees.

Frequently Asked Questions (FAQs)

1. Why is the Real Effective Exchange Rate important?

REER is more than just an indicator. It is used by many world authorities like IMF, World Bank, and BIS. It is employed in the study of 133 countries in combination with other indicators. It is also taken into account during policymaking to assess economic growth.

2. What is the Real Effective Exchange Rate in economics?

REER is the weighted average of any country’s currency in comparison to currencies belonging to other countries. Sometimes REER compares one country’s currency to an index. It is an important metric; global organizations use it to compare economic growth, competitiveness, and regulation policies. REER compares the relative trade balance of a country’s currency with the index.

3. What does a higher Real Effective Exchange Rate mean?

A higher REER paints a scenario where the exports are expensive and imports are cheaper. So it points toward a loss in trade competitiveness. However, it can easily be understood that exports are higher because the purchasing power of the domestic country is low compared to other countries, whereas the imports are cheap. After all, foreign currencies have a high purchasing power.

This article has been a guide to Real Effective Exchange Rate and its definition. We explain its formula, index, and example. You can learn more about it from the following articles –

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