Nominal and Real Effective Exchange Rate: Explained

 

Nominal exchange rate is the price of one currency in terms of number of units of some other currency. This is determined by fiat in a fixed rate regime and by demand and supply for the two currencies in the foreign exchange rate market in a floating rate regime.

It is ‘nominal’ because it measures only the numerical exchange value, and does not say anything about other aspects such as the purchasing power of that currency. In a floating rate regime, an increase in the value of the domestic currency against other currencies is called an appreciation, while a decrease in value is called depreciation. In contrast, an increase in the exchange rate in a fixed rate regime is called a revaluation (for an increase) and a decrease in the exchange value of the domestic currency is referred to as a devaluation.

What is real exchange rate?

To incorporate the purchasing power and competitiveness aspect and, therefore, make the measure more meaningful, real exchange rates are used. The real exchange rates are nothing but the nominal exchange rates multiplied by the price indices of the two countries. This means the market price level of goods and services, given by indices of inflation. So if the price level in the US is higher than the price level in India, then the real exchange rate of the rupee versus the dollar will be greater than the nominal exchange rate. Suppose the nominal exchange rate is Rs 50 and US prices are greater than Indian prices, a dollar will buy more in India than what Rs 50 will buy in the US. So the real rupee-dollar exchange rate is greater than the nominal rate. If the real exchange rate is calculated using the price levels of common traded goods, then it gives a measure of export competitiveness. For example, if both the US and India manufacture the same (or highly comparable) pharmaceutical drug, and Indian drug prices are lower than US prices, then the exchange rate in terms of drugs is favourable to India. This can be generalized to all the goods manufactured by the two economies that compete in the export market. If the real rupee-dollar exchange rate based on export-competing goods depreciates, then Indian exports enjoy an enhanced pricing advantage over US goods. The converse is true for a real appreciation.

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What are NEER and REER?

NEER is the Nominal Effective Exchange Rate, and REER is the Real Effective Exchange Rate. Unlike nominal and real exchange rates, NEER and REER are not determined for each foreign currency separately. Rather, each is a single number (usually expressed as an index) that expresses what is happening to the value of the domestic currency against a whole basket of currencies. These other currencies are picked on the basis of that country’s trade with the domestic economy. India trades with a large number of countries such as the US, EU, Japan and Middle East. With each individual currency, the rupee has a different nominal exchange value. To calculate NEER we weight the nominal exchange rate of the rupee against the currencies of these trading partners by their share in India’s trade. Then, by summing the weighted exchange rates, we get the NEER. By setting the NEER for some year at 100, we can track changes in the rupee’s value as percentage changes over the base year.

How is REER calculated?

Similar to the NEER, the REER is the weighted average of real exchange rates, weighted by the relative importance of each country in trade with the domestic economy. In other words, like the NEER, the REER is an index of a country’s real exchange rate, a single number which gives some reference or benchmark about how the currency is performing in relation to the rest of the world as a whole, rather than just individual countries. Both these measures are useful as benchmarks that give an idea of the general movement of the domestic currency against the rest of the world. Theory tells us that if the domestic currency becomes more expensive in terms of other currencies, then exports will become less valuable in terms of the domestic currency and imports will become cheaper. The converse is true if the domestic currency weakens (in nominal and real terms).

 

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