• Amoghavarsha IAS Broucher
  • +91 9916766911 / 8088776736
  • info@amoghavarshaiaskas.in
  • E-Learning
  • Blog

Real Effective Exchange Rate (REER)

Introduction to REER

The Real Effective Exchange Rate (REER) is a weighted average of a country’s currency relative to a basket of major trading partner currencies, adjusted for inflation. It offers a more accurate measure of currency value than the nominal exchange rate, as it takes into account changes in both exchange rates and price levels (inflation) in various countries.

REER is considered a broad measure of a country’s competitiveness in international markets, indicating whether a currency is overvalued or undervalued compared to its trading partners.

Nominal Effective Exchange Rate (NEER) vs. REER

Before delving into REER, it’s important to understand the difference between Nominal Effective Exchange Rate (NEER) and REER:

  • NEER is the weighted average of a country’s exchange rates relative to the currencies of its major trading partners, without considering inflation. It simply reflects the market exchange rates.

  • REER, on the other hand, adjusts the NEER for relative inflation rates between countries, providing a more accurate measure of the currency’s real value in terms of competitiveness.

Calculation of REER

The formula for calculating the REER is as follows:

REER=NEER×(PdomesticPforeign)REER = NEER \times \left( \frac{P_{\text{domestic}}}{P_{\text{foreign}}} \right)

Where:

  • NEER is the Nominal Effective Exchange Rate.
  • P_domestic is the price index of the domestic country.
  • P_foreign is the weighted average of price indices of trading partners.

In simpler terms, the REER accounts for:

  1. Nominal exchange rates between countries.
  2. Inflation differentials between the home country and its trading partners.
  3. Weightage of trading partners based on the volume of trade.

Importance of REER

  1. Assessing Competitiveness:
    REER is an essential tool to gauge a country’s external competitiveness. A rising REER signifies a stronger currency, which can make exports more expensive, affecting international trade. Conversely, a falling REER suggests a depreciating currency, enhancing the competitiveness of a country’s exports.

  2. Impact on Trade Balance:
    A country with a higher REER may experience decreased exports and increased imports, as its goods become more expensive and foreign goods cheaper. This can lead to a trade deficit.

  3. Inflation Control:
    REER reflects the inflation-adjusted value of a currency, which helps policymakers in managing inflation. A higher REER suggests that inflation has eroded the competitiveness of exports.

  4. Policy Formulation:
    Governments and central banks use REER to make informed decisions about exchange rate policy, monetary policy, and trade agreements.

REER and Economic Indicators

  • Inflation and Its Role:
    Inflation plays a key role in the calculation of REER. A rise in inflation in a country relative to its trading partners leads to an appreciation of the nominal exchange rate and a decrease in the real exchange rate. This can erode a country’s external competitiveness over time.

  • Trade Balance Impact:
    A rising REER typically leads to higher imports and lower exports, as the cost of domestic goods becomes higher in foreign markets. Conversely, a declining REER can boost exports and reduce imports, improving the trade balance.

  • Foreign Exchange Reserves:
    REER impacts the demand for foreign currencies in international markets. Countries with stronger REER may experience capital inflows, as foreign investors seek to take advantage of the appreciating currency.

REER and India: A Case Study

India, with its large and diverse economy, is highly dependent on both imports and exports. The Indian Rupee (INR) is influenced by multiple factors such as global commodity prices, foreign investment inflows, and domestic inflation. In recent years, India’s REER has fluctuated, often reflecting global economic conditions.

  • Impact of a Strong INR:
    A stronger INR (higher REER) may reduce the competitiveness of Indian exports, especially in sectors like textiles, engineering goods, and IT services, which are highly sensitive to price changes in the global market.

  • Impact of a Weak INR:
    A weaker INR (lower REER) may boost Indian exports, but it also increases the cost of imports, particularly crude oil and other key commodities. This has an inflationary effect, leading to higher domestic prices.

  • Monetary Policy and REER:
    The Reserve Bank of India (RBI) often monitors REER when formulating policies. A sudden shift in REER can prompt the central bank to adjust interest rates, manage inflation, or intervene in the foreign exchange market.

REER and Global Economy

  1. Global Trade and Competitiveness:
    In the global economy, countries with a high REER face challenges in terms of export competitiveness, as their products become more expensive. For example, countries like the United States and Eurozone have faced trade imbalances due to the strength of their currencies (high REER).

  2. China and REER:
    China has historically maintained a low REER by keeping its currency undervalued, thus gaining a competitive edge in exports. However, in recent years, China has seen an appreciation of its currency, which is impacting its export-driven economy.

  3. Currency Wars and REER:
    The concept of currency wars (competitive devaluation) is often linked to the REER. Countries intentionally devalue their currencies to boost exports, leading to international tensions. A significant fall in the REER can result in global imbalances, affecting trade and diplomatic relations.

Factors Affecting REER

  1. Inflation Differential:
    A major factor in REER movements is the inflation differential between countries. Countries with lower inflation tend to have a stronger REER as their goods become relatively cheaper for foreign buyers. On the contrary, high inflation erodes a country’s competitiveness, leading to a decline in REER.

  2. Exchange Rate Fluctuations:
    Currency fluctuations, influenced by market forces, government policies, and external factors, can cause significant changes in REER.

  3. Global Economic Trends:
    Events such as recessions, oil price shocks, or trade wars can impact the REER by altering inflation rates or currency values.

  4. Government and Central Bank Policies:
    Exchange rate policies, interest rate changes, and interventions in the foreign exchange markets can influence the REER. For instance, central banks may devalue their currency to boost exports, thereby reducing the REER.

Conclusion

The Real Effective Exchange Rate (REER) is a critical measure of a country’s international competitiveness. It reflects both exchange rates and inflationary differences, offering a more accurate picture of currency value compared to nominal rates. For UPSC aspirants, understanding REER helps in comprehending complex issues related to international trade, monetary policy, inflation, and economic development. A well-rounded understanding of REER will allow candidates to connect macroeconomic indicators and their influence on global and domestic markets.

Maximize the benefits of mock tests for IAS and KAS preparation with guidance from Amoghavarsha IAS Academy . For more details, visit https://amoghavarshaiaskas.in/.

Youtube: click here

Enroll Now !
Media & News
Similar Articles for UPSC Aspirants

Sir Creek issue

The Sir Creek dispute is a long-standing territorial and maritime boundary conflict....

Operation Vijay 1961 Goa

Operation Vijay (1961) was a significant military action undertaken by India to....

Operation Vijay Kargil War

The Kargil War of 1999, fought between India and Pakistan, was one....

Bangladesh Liberation War

The Bangladesh Liberation War of 1971 was a defining moment in South....

Operation Searchlight

Operation Searchlight was a brutal military campaign launched by the Pakistan Army....

South-South Climate Cooperation

Facebook Youtube Instagram Whatsapp Linkedin X-twitter Telegram

Amoghavarsha IAS KAS

DOWNLOAD APP
Bangalore
Tumkur Free Coaching Registration
Mysore
Hassan
Nelamangal
About us

Amoghavarsha IAS/KAS Academy was founded in 2014 since from their we have been excellence in the field of civil Service examination preparation and state services. The Academy is completely dedicated to provide excellent quality education by experts and bringing innovations etc.

Popular Courses
  • Upcoming Events
  • Prelims Test Series
  • KPSC KAS Courses
  • Optional Subject Classes
  • Integrated Foundation Program
Contact us
  • +91 9916766911 / 8088776736
  • info@amoghavarshaiaskas.in
  • No 117/32 , 2nd Floor, 1st Main Rd, near Hoshalli metro station, Hoshalli Extension, Stage 1, Vijayanagar, Bengaluru, Karnataka 560040

Copyright © 2014 – 2024 Amoghavarsha IAS Academy. All Rights Reserved

Developed & Maintained by BIGGSITE– Manikanta G.V

About Us

Amoghavarsha E Magazine

Current Affairs ( Prelims )

Current Affairs ( Mains )

UPSC

KPSC

  • Gazetted Probationers
  • Group C
  • CC Model Test Series

Exclusive Free Coaching for Tumkur University Students

Register Now !