What is the Real Effective Exchange Rate?

The Real Effective Exchange Rate (REER) is an indicator of the external competitiveness of a country's currency. It is the weighted average of a country's currency against a basket of other major currencies (after adjusting for inflation differentials). The REER is expressed as an index number relative to a base year.

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How does the Real Effective Exchange Rate Work?

The relative trade balance of a countrys currency is compared against each of the existing countries in the index for calculating the weights. This exchange rate determines the specific currencys value compared to other major currencies in the index. The nominal effective exchange rate (NEER) of a currency is its value compared with a weighted average of other foreign currencies. The real effective exchange rate of a currency is calculated by adjusting the nominal effective exchange rate to include price indices and other trends. Basically, the real effective exchange rate is the nominal effective exchange rate minus the price inflation or labor cost inflation. To compute the REER of a countrys currency, the NEER is to be adjusted by the appropriate foreign price level and it is to be deflated by the home country price level. REER indicates the price a consumer pays for buying an imported product. It includes the tariffs and other transaction costs involved in importing the product. The REER of a countrys currency can be calculated in various methods. It can be calculated by weighing the average of the bilateral exchange rates between the country and its trade partners using the trade allocation of each. Calculating REER based on the consumer price index or on unit labor cost is the most common practices. The IMF computes the REER based on consumer price index for almost all the countries and unit-labor-cost-based REER is used for most of the industrial nations. Whatever the method of calculation may be, the REER indicates the equilibrium value of the currency. It measures the countrys trade capabilities and export-import condition. It detects the underlying factors of the trade flow and takes into consideration all the changes in the international price. REER is an important measure that needs to be considered during policy making and when scrutinizing the economic growth of a country. Institutions like IMF, World Bank, BIS and others publish REER indicators and provides REER analysis of 133 countries by combining the indicators.

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