Real Effective Exchange Rate (REER)

Context:

The Real Effective Exchange Rate (REER) of the rupee moderated in December to 107.20 after hitting a peak of 108.14 in November, latest data released by the Reserve Bank of India (RBI) showed. The REER was 103.66 in January 2024.

Real Effective Exchange Rate (REER): Background and Formula

The Real Effective Exchange Rate (REER) is the value of a country’s currency relative to a basket of other currencies, adjusted for inflation. A country’s REER can be indicative of such factors about the country’s outward position and macroeconomic condition.

How REER is Calculated

• Nominal Effective Exchange Rate (NEER):
  • It is the ratio of a country’s currency value to a weighted average of other currencies.
  • The weightings are based on the trade relationships a country has with its major trading partners.
• Price Deflator:
  • The REER is adjusted for inflation using a price deflator.
  • The deflator is usually a consumer price index and is an indicator of changes in the domestic cost level.
• Formula:
  • REER = (Nominal Effective Exchange Rate) / (Price Deflator)

What REER is Used For

• Determining External Imbalances:
  • The REER can be used to determine if there are any imbalance in a country’s external trade.
• High REER
  • A high REER may indicate that a country’s currency is overvalued, making its exports less competitive.
• Low REER
  • A low REER may indicate that the currency is undervalued, which could be detrimental to the country’s purchasing power.
• Currency Valuation:
  • REER is used to determine whether a currency is misvalued. A large deviation from the equilibrium REER may indicate currency misalignment.
• Economic Crises Indicator:
  • Some economists also view the REER as a precursor to economic crises, especially for countries facing chronic imbalances in their current account.
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Determinants of REER

• Trade Flows:
  • The REER changes with variations in trade flows between a country and its trade partners, influencing its currency’s relative competitiveness.
• Fluctuations:
  • A change in trade pattern (due to trade agreements, tariffs) is a reason for fluctuations in REER.
• Inflation:
  • Because the REER has inflation adjustment, any relative inflation between countries will influence the value.
• Interest Rates:
  • A change in a country’s interest rates may affect its currency value and subsequently its REER.
• The greater the inflation level of a country compared with that of its trading partners, the lower the country’s REER will be, this indicates that the country lost external competitiveness.
• Higher interest rates may attract capital inflows, strengthening the currency and affecting the REER.

Source: Business Standard