What is the Real Effective Exchange Rate?

The Real Effective Exchange Rate (REER) 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.

The REER is an indicator of the external competitiveness of a country's currency.

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How is the Real Effective Exchange Rate Calculated?

The relative trade balance of a country's currency is compared against each of the existing countries in the index for calculating the weights. This exchange rate determines the specific currency's value compared to other major currencies in the index.

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 real effective exchange rate is the nominal effective exchange rate minus the price inflation or labor cost inflation. 

What is the Nominal Effective Exchange Rate? 

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. 

To compute the REER of a country's 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. 

Calculating the REER of a Country's Currency with Another Currency

The REER of a country's currency can be calculated in various methods. 

Method 1

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. 

Method 2

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. 

How is the REER of a Country Used?

The REER measures the country's 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. 

It is used by central banks and the international monetary fund when determining lending practices, such as accessibility, exchange, and interest rates. 

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