The Real Effective Exchange Rate (REER): Measure Your Currency’s Strength and Trade Competitiveness
The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against that of each country in the index.
An increase in a nation’s REER indicates that its exports are becoming more expensive and its imports are becoming cheaper, signifying a loss of trade competitiveness.
Highlighting Key Insights
- Definition: REER compares a nation’s currency value against the weighted average of the currencies of its major trading partners.
- Assessment: It indicates the international competitiveness of a nation in comparison with its trade partners.
- Weighting: Formula utilizes relative importance of each trading partner to the home country.
- Impact: An increasing REER denotes a decreasing competitive edge.
- Calculation: A nation’s nominal effective exchange rate (NEER), adjusted for home country inflation, results in its REER.
Steps to Calculate the Real Effective Exchange Rate (REER)
The state’s REER measures how well the equilibrium is being maintained, ensuring balance between supply and demand. Here’s how to calculate it:
The Calculation Formula Explained
Breaking down the formula:
- Calculate the weighted average by assigning a specific power for each exchange rate. For instance, a currency with 60% weighting will be raised to the power of 0.60.
- Multiply all of the exchange rates.
- Multiply the final result by 100 to create the scale or index.
REER reflects whether a currency is overvalued or undervalued in relation to its trading partners.
What REER Tells You About Your Country’s Trade
REER is crucial for assessing a country’s trade capabilities. It can reveal:
- Equilibrium Value: Whether a currency is fairly valued.
- Trade Dynamics: Factors driving a country’s trade flow.
- Market Impacts: Effects of competition and technology changes.
For example, if the U.S. Dollar weakens against the Euro, American goods become cheaper for Europeans, boosting U.S. exports to Europe.
Practical Example of REER
Suppose the U.S. maintains trading relationships exclusively with the eurozone, Great Britain, and Australia. Here’s how it works in a nutshell:
- U.S. trades 70% with eurozone, 20% with Great Britain, and 10% with Australia.
- Any significant change in the Euro would impact REER substantially due to its high percentage in the trade balance.
Comparing REER with Spot Exchange and NEER
Spot Exchange Rate: The current price to exchange one currency for another for the earliest possible date.
Nominal Effective Exchange Rate (NEER): The average rate a country’s currency is valued against other currencies, adjusted for domestic inflation to derive REER.
Considerations and Limitations of REER
Several factors other than direct trade, such as price changes, tariffs, or financial market fluctuations, can influence REER. It doesn’t factor in non-trade related elements like altered interest rates due to central bank policies, which could significantly impact currency strength.
Conclusion: Determining Economic Health through REER
REER is essential for evaluating a nation’s economic health and trade relationship dynamics. Accurate calculation and continuous monitoring enable better management of international competitiveness.
Related Terms: Nominal Effective Exchange Rate, Real Exchange Rate, Weighted Average, Equilibrium, Spot Exchange Rate
References
- Bank for International Settlements. “Effective exchange rate indices”.
- International Monetary Fund. “What is real effective exchange rate?”
