Understanding the Nominal Effective Exchange Rate (NEER)
The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. The nominal exchange rate indicates the amount of domestic currency required to purchase foreign currency.
In the realm of economics, NEER serves as an indicator of a country’s international competitiveness in the foreign exchange (forex) market. Forex traders often refer to the NEER as the trade-weighted currency index.
Moreover, NEER can be adjusted to account for the home country’s inflation rate relative to its trading partners’ inflation rates, resulting in the real effective exchange rate (REER). Unlike direct currency pair relationships, NEER provides an index that expresses how a domestic currency’s value compares against multiple foreign currencies simultaneously.
During a floating exchange rate regime, a domestic currency’s appreciation against a basket of other currencies signifies an increased NEER. Conversely, a decrease in the currency’s value against the basket results in NEER depreciation.
Insights from the Nominal Effective Exchange Rate (NEER)
While NEER describes relative value, it does not definitively determine if a currency is strong or gaining strength in real terms. Instead, NEER reflects whether a currency is weak or strong, or weakening or strengthening compared to foreign currencies. NEER serves as a crucial tool in evaluating currencies’ capacity to store value. Exchange rates significantly affect international trade dynamics, influencing where global actors decide to buy or sell goods.
Economists utilize NEER for policy analysis and international trade studies, while forex traders deploy it for currency arbitrage activities. Notably, the Federal Reserve calculates three distinct NEER indices for the United States: the broad index, the Advanced Foreign Economies (AFE), and the Emerging Market Economies (EME).
The Basket of Foreign Currencies:
Every NEER benchmark compares a single currency against a basket of foreign currencies. This basket is curated based on the domestic country’s most critical trading partners and other significant currencies. The principal global currencies include the U.S. dollar, the Euro, the British pound, the Japanese yen, the Australian dollar, the Swiss franc, and the Canadian dollar.
Weights assigned to foreign currencies in the basket reflect the trade value with the domestic country. These weights could be based on export or import value, total trade value, or other relevant measures related to countries’ assets and liabilities.
A higher NEER coefficient (above 1) signifies that the domestic currency is often worth more than imported currencies, whereas a lower coefficient (below 1) indicates the opposite.
There’s no universal rule for selecting a currency basket. For instance, the Organization for Economic Co-operation and Development (OECD) basket differs from those used by the International Monetary Fund (IMF), Federal Reserve, or Bank of Japan. However, numerous institutions rely on the International Financial Statistics (IFS) published by the IMF as a reference.
Related Terms: Real Effective Exchange Rate, Forex Market, Exchange Rates, International Trade, Currency Appreciation, Currency Depreciation
References
- The Federal Reserve System. “Foreign Exchange Rates—H.10”.
