Effective Exchange Rates: NEER and REER

  May 02, 2024

Effective Exchange Rates: NEER and REER

Effective exchange rates (EERs) serve as a indicator  for assessing the fair value of a currency, the external competitiveness of an economy and even serve as guidelines for setting monetary and financial conditions.An EER is a summary indicator of movements of the home currency against a basket of currencies of trading partners. The nominal effective exchange rate (NEER) is an index of the weighted average of bilateral exchange rates of home currency with  currencies of trading partners, with weights derived from their shares in the total trade basket of the home currency. A real effective exchange rate (REER) is the NEER adjusted to  inflation differentials between the home economy and trading partners. Conceptually, EERs are founded on the purchasing power parity (PPP) measure. 

Structural changes in the Indian economy and shifts in pattern of India’s foreign trade warranted updates to the broad indices of nominal/ real effective exchange rate (NEER/REER) of the Indian rupee. The current basket  expanded from 36 to 40 currencies, with the inclusion of eight new currencies and exclusion of four currencies. The base year is 2015-16. 

NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) are both measures used to assess the value of a country's currency relative to the currencies of its trading partners:

NEER (Nominal Effective Exchange Rate):

NEER is a way to measure the overall value of a country’s currency compared to a basket of foreign currencies. This index is calculated by taking an average of the bilateral exchange rates between the home country and its trading partners, weighted by their respective trade balances. NEER indicates  how much the currency lost or gained value against other important currencies from home currency point of view.NEER is like the average exchange rate of the Indian Rupee (INR) against a basket of currencies from India's major trading partners. It's a weighted average, so currencies from countries India trades with heavily are given more importance.Factors Influencing NEER:

● Exchange Rates: The direct exchange rate between your currency and that of major trading partners.

● Trade Weights: The importance of each trading partner, reflected by how much you import and export to/from them.

● Economic Conditions: Broad factors like interest rates, economic growth, and political stability can also indirectly influence NEER

REER (Real Effective Exchange Rate):

● REER builds upon the concept of NEER by also considering the price levels or inflation rates of the home country and its trading partners. This adjustment makes REER a more accurate measure of a currency’s competitiveness than NEER.

● REER essentially indicates how many goods and services in the home country can be exchanged for goods and services in another country after adjusting for price level differences. A higher REER implies that the home country’s goods are more expensive and less competitive compared to foreign goods.Currency appreciation, accompanied by price fall ,keeps goods and services price-competitive. And vice versa, for depreciation.In other words, NEER does not tell the whole story. Unless adjusted to inflation and REER is worked out, trade dynamics can not be worked out on ground. 

● REER = NEER + Inflation AdjustmentsKey Influence: Inflation differentials between home country and its trading partners are the primary factor that distinguishes REER from NEER.

● In simple terms, REER is the buying power of the Indian Rupee against other currencies, considering inflation. It's like adjusting the NEER for the differences in the cost of living (inflation rates) between India and its trading partners.

If a currency's NEER strength stems primarily from low inflation, its exports are likely to remain strong. Here's why:NEER and Relative Prices: A stronger NEER implies that a country's currency is appreciating (gaining value) against its trading partners' currencies. When this is accompanied by low inflation, the country's goods become relatively cheaper for foreign buyers.Price Competitiveness: If a country has low inflation, it can control the prices of its goods on the global market. This improves its price competitiveness making its exports more attractive to foreign buyers.Increased Demand: As the country's exports become relatively cheaper, there should be an increase in demand from foreign markets. This generally leads to stronger exports.

 Real Effective Exchange Rates (REER) are based on CPI.

NEER and REER can be calculated for various periods:

● Daily: NEER and REER can be calculated daily to reflect the constantly changing exchange rates.

● Monthly: Monthly calculations are common for tracking trends and seeing how exchange rates change over a slightly longer time frame.

● Annually: You can certainly calculate annual NEER and REER. This provides a broader picture of changes over a whole year and is useful for comparing year-to-year trends.

Which period is used depends on the purpose of the analysis:

● Short-term analysis: Daily or monthly NEER/REER is more useful for traders and those interested in short-term market movements.

● Long-term trends: Annual NEER/REER is often better for policymakers and those concerned with broader economic trends.

NEER is a notional concept.Nothing trades at either NEER or REER. The official exchange rate may not agree with either. But, it is expected that NEER should trend towards REER in course. 



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