When trading foreign exchange or Forex, there are a few terms that traders will come across frequently. One of the most fundamental of these is the term REER. This stands for Real Effective Exchange Rate and refers to the value of one currency versus another. The other is NEER, which is the Nominal Effective Exchange Rate.
This article will go over these terms in detail to provide an idea to the new traders.
Before understanding NEER and REER, let us understand what an "Effective Exchange Rate (EER) " is. It is the summary of the movement indication of the domestic currency against a complete basket of other global currencies of its trading partners. In simple terms, the EER indicates the external competitiveness of the economy. This is done in terms of how competitive the domestic currency is, as compared to the other currencies that the country trades with.
Nominal Effective Exchange Rate (NEER)
The full form of NEER is Nominal Effective Exchange Rate. The NEER may be defined as a weighted average of one country's currency that is needed to purchase a foreign currency. The weight of trading is higher for countries with whom the home country (India) trades more.
This concept is very relevant in economics wherein NEER, or the Nominal Effective Exchange Rate, measures the domestic currency's competitiveness in the international forex (foreign exchange) market.
One advantage of the NEER is that it helps a country to understand its currency's current weakness or strength against other global currencies. Thus, the NEER of a country is used in policy analysis for all international trade and by forex traders for currency arbitrage.
Real Effective Exchange Rate (REER)
The Real Effective Exchange Rate (REER) can be defined as the NEER that is price- or cost-adjusted exchange rate against the inflation differentials in the two economies, i.e., the home country and its trading partner. It is a fundamental concept in a country's economic status.
Both NEER and REER are a part of the Purchasing Power Parity hypothesis. This is because both NEER and REER define the strength or weakness of a currency as against another currency but cannot be determined in absolute terms.
REER may be used to compare the worth of one nation's currency to the currencies of other nations. A REER value greater than 100 for a particular year implies that the currency has been overrated. On the other hand, if the REER value is within 100 in a given year, that currency is currently undervalued.
Now, for instance, if the Indian Rupee falls in value versus the euro, Indian goods when shipped to Europe, will eventually become less expensive. To purchase our exports, European firms or individuals must transfer their euros to rupees. If the rupee falls in value relative to the euro, each euro will fetch more rupees, making Indian goods less expensive.
India has a significant commercial connection with Europe. As a result, the euro to Indian rupee rate of exchange would have a higher weightage. A major shift in the euro rate of exchange would have a greater impact on the Real Effective Exchange Rate than if any other (lower weighted) currency gained or weakened versus the rupee.
The Formula for REER
A country's currency may be regarded as overvalued, undervalued, or currently in balance with the set currencies of other nations with which it deals. In an equilibrium condition, supply and demand levels are evenly balanced, and prices stay steady.
A country's REER measures how well that balance is maintained. REER is computed by considering the average amount of the bilateral rates of exchange. This is done between a nation and its trading partners. It is then adjusted to account for the country's trade allocation.
The formula for REER is:
Here, CER means the exchange rate of the country.
And n means the weightings for each rate.
Basically, REER shows whether the currency is overvalued or undervalued with respect to the other currencies.
Is NEER greater than REER?
NEER is a weighted average that is not adjusted to the prevailing inflation or the purchasing power of the country. It is the exchange rate of one country relative to a basket of exchange rates of all countries with which it trades. REER is calculated based on NEER and is inflation adjusted according to the purchasing power of the country. Hence, REER is always less than NEER.
Who decides the nominal exchange rate?
The Reserve Bank of India computes NEER and the REER, both trade and exchange-weighted. It computes the rupee's value in relation to two indexes, one of which includes six nations while the other includes 36 nations with a 2004-05 basis. Since India is growing at a fast pace and intends to increase its global competitiveness in foreign trade, the currency basket has increased from 36 countries to 40 countries now since the RBI started publishing the CIP-based REER in April 2014. So, now the base year has shifted from 2004-05 to 2015-16.
What is the difference between REER and Spot Exchange Rate?
A spot rate of exchange is the current rate at which one currency can be exchanged for another currency for delivery upon this earliest available value date. This value date can be defined as the effective date of a financial transaction that involves an asset that is price-sensitive.
For example, the spot exchange rate for a specific date would entail the amount (in INR) needed to buy dollars. However, even though the spot rate of exchange is for delivery on the earliest possible date, many spot transactions are settled two business days following the transaction date.
As a result, the spot rate of exchange is just a present market price. However, the REER measures the value of a currency concerning the country's trade partners.
What are the drawbacks of the Real Effective Exchange Rate?
Aside from commerce, other factors might influence the REER. The real effective rate of exchange does not account for price fluctuations, tariffs, and other variables that may impact international commerce. If one nation's prices are higher than another's, commerce in the higher-priced nation may decline, affecting its REER.
Any variations in trade must therefore be included in the weighting employed in the REER computation. Furthermore, each nation's central bank alters its money supply, which might cut or boost rates of interest in the home nation. As investors seek returns, the money flow to nations with higher rates may grow, increasing the exchange rate of currencies.
The REER amount would be affected, but it would be due to the rate of interest markets rather than trade.
The Bottom Line
As you can see, there are a lot of intricacies that come with these two terms. To trade for the best chance of success, it is vital to understand exactly what REER and NEER are and how they can affect your trading decisions. Traders need to make sure that they keep up to date on both of these terms so that they know exactly where profits may lie at any given time.
Frequently Asked Questions
How is the nominal exchange rate adjusted for inflation?
The central bank of a country utilises the REER or real effective exchange rate concept to alter the nominal effective exchange rate to account for inflation. The REER is conceptually the weighted average amount of nominal exchange rates, which are adjusted for the price disparity between the home and foreign nations. The price difference, on the other hand, is founded on the purchasing power idea. The currencies utilised are those of the most important trading partners.
Can nominal exchange rates be negative?
Yes. The negative value of the exchange rate between two currencies, A and B, indicates that A is worth more than B. Thus, if the exchange rate is positive, it indicates that the home currency has appreciated, and if negative, it simply means that the home currency has depreciated.
How does the RBI calculate REER?
The RBI computes the rupee's value in relation to two indexes, one of which includes six nations while the other includes 36 nations with a 2004-05 basis. The Reserve Bank of India utilises index-based wholesale price inflation, while consumer price indices are utilised internationally.
Is there any difference between the Real Exchange Rate and Real Effective Exchange Rate?
The real exchange rate is the cost of a particular product or asset in a different currency. The real effective exchange rate is the relative rate of exchange with respect to a basket of trade currencies.
What does a higher REER mean?
A rise in REER suggests that exports of the company become more costly and the imports get cheaper; hence, an increase signals a decline in trade competitiveness.
What does a low REER mean?
A decline in REER suggests that exports of the company become less costly and the imports get expensive; hence, an increase signals a rise in trade competitiveness.
What causes the real exchange rate to decrease?
Here are the possible reasons for the real exchange rate decrease:
- Rates of Interest
- Current Account Deficits
- Public Debt
- Trade Terms
- Strong Economic Performance.
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