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Real Effective Exchange Rate (REER) Definition
The Real Effective Exchange Rate (REER) is an indicator of the external competitiveness of a country’s currency. It 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.
A Little More on What is the Real Effective Exchange Rate
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.
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. Basically, the real effective exchange rate is the nominal effective exchange rate minus the price inflation or labor cost inflation.
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.
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 REER of a country’s currency can be calculated in various methods. 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.
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. It 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.
REER is an important measure that needs to be considered during policy making and when scrutinizing the economic growth of a country.
Institutions like IMF, World Bank, BIS and others publish REER indicators and provides REER analysis of 133 countries by combining the indicators.
References for the Real Exchange Rate
Academic Research on Real Exchange Rate
The real exchange rate and economic growth, Rodrik, D. (2008). Brookings papers on economic activity, 2008(2), 365-412. This paper indicates that undervaluation of a currency enhances economic growth mostly in developing countries. It also provides evidence proving that the operative channel is the size of the sector that is tradable. A formal model is used to explain the relationship between real exchange rate and economic growth rate.
Capital inflows and real exchange rate appreciation in Latin America: the role of external factors, Calvo, G. A., Leiderman, L., & Reinhart, C. M. (1993). Staff Papers, 40(1), 108-151. This article explains the characteristics of the recent capital inflows into Latin America and argues that some part of the inflows can be explained by prevailing conditions outside the region like the decreased international exchange rates or the US recession. A reversal of these conditions could cause a macroeconomic vulnerability in the area due to future capital outflows.
Accounting for US real exchange rate changes, Engel, C. (1999). Journal of Political Economy, 107(3), 507-538. This research measures the percentage of US real exchange rate movements that can be explained by the changes in relative prices of non-traded goods. A study is carried out using five distinct measures of prices of non-traded goods and real exchange rates, for US exchange rates relative to several high-income countries in each instance.
Sources of real exchange–rate fluctuations: How important are nominal shocks?, Clarida, R., & Gali, J. (1994, December). In Carnegie-Rochester conference series on public policy (Vol. 41, pp. 1-56). North-Holland. This is an empirical investigation that aims at identifying the causes of real exchange fluctuations since when Bretton Woods collapsed. It attempts to develop and estimate a three equation open macro model and determine the structural shocks of the model using an approach introduced by Blanchard and Quah (1989). The short-run dynamics of this model are similar to the predictions made by the Mundell-Fleming model.
Real exchange rate behavior: the recent float from the perspective of the past two centuries, Lothian, J. R., & Taylor, M. P. (1996). Journal of political economy, 104(3), 488-509. This paper presents strong evidence pertaining to mean-reverting exchange rate behavior by using two centuries worth of data for dollar-sterling and franc-sterling real exchange rates. It utilizes simple, stationery and autoregressive models which are estimated on prefloat data to perform better than the real exchange rate models in dynamic forecasting exercises over the new float.
The terms of trade, the real exchange rate, and economic fluctuations, Mendoza, E. G. (1995). International Economic Review, 101-137. This is an examination of the terms of trade’s relationship with business cycles through the use of a three-sector intertemporal equilibrium model and an extensive multi-country database. This model is used to explain the weak correlations net exports and terms of trade and gives large and weakly-correlated deviations from real interest rate parity and purchasing power parity.
Real exchange rate risk, expectations, and the level of direct investment, Cushman, D. O. (1985). The Review of Economics and Statistics, 297-308. This paper assumes several relationships between foreign and domestic production in the analysis of four models of direct investment. It uses gathered estimation results from US annual, and bilateral direct investment flows to five industrialized countries, to present major reductions that are associated with the expected appreciation of the real foreign currency and significant increments related to risk.
Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations, Burstein, A. T., Neves, J. C., & Rebelo, S. (2003). Journal of monetary Economics, 50(6), 1189-1214. This article explains the role of distribution costs in determining the behavior of the real exchange rate during exchange-rate-based stabilizations. It states that distribution efforts require local labor and land, and so they cause differences between retail prices of different countries. It also explains that introducing a distribution sector in standard models of exchange-rate-based stabilizations significantly improve their rationalization of observed real exchange rate dynamics.
Dynamic equilibrium and the real exchange rate in a spatially separated world, Dumas, B. (1992). The Review of Financial Studies, 5(2), 153-180. This article uses a case study of two homogenous stocks of physical capital that are in two different countries and which are consumed by residents in those countries, invested in a production process with real returns or transferred outside the countries. It states that in these two countries, the heteroskedastic process for the relative price of capital tends to have a nonlinear, mean-reverting drift.
Real exchange rate misalignments and growth, Razin, O., & Collins, S. M. (1997). (No. w6174). National Bureau of Economic Research. This paper develops an indicator of real exchange rate misalignment (RER) for a significant sample of developed and developing countries. It also utilizes regression analysis to investigate whether these RER misalignments have any relationship with a country’s growth experiences. The findings state that there are essential non-linearities in the relationship.
The effects of real exchange rate risk on international trade, Cushman, D. O. (1983). Journal of international Economics, 15(1-2), 45-63. This study concludes that there is uncertainty in the percentage changes of the risky real exchange rates in international trade, through the assumption of real profit maximization, uncertain prices and exchange rates. It uses an estimation of fourteen bilateral trade flows between industrialized countries which finds an adverse effect on trade quantity from this risk in various cases.
Real exchange rate behavior and economic performance in LDCs, Cottani, J. A., Cavallo, D. F., & Khan, M. S. (1990). Economic Development and Cultural Change, 39(1), 61-76. This paper investigates whether real exchange rate behavior and economic performance are correlated using realistic evidence obtained from a cross-section of LDCs. A real exchange rate model which combines time series with cross-sectional data is also developed. The model is used to calculate a regression-based index of misalignment that considers the difference between sustainable as well as actual values of the policy variables used as regressors.