Nominal and Real Effective Exchange Rates

The currencies are exchanged and converted based on the exchange rates to carry out an easy foreign trade among different nations. In India, RBI has coined two significant exchange rates, nominal effective exchange rates, and real effective exchange rates. These exchange rates are major indicators of a nation’s competitiveness and also a major indicator of currency’s performance. 

What is the Nominal Effective Exchange Rate (NEER)?

The Nominal Effective Exchange Rate (NEER) is a weighted index of nominal exchange rates of the local currency in terms of foreign currency. Simply, it can be understood as the specific local currency amount required to buy a foreign currency. The NEER indicates a nation’s competitiveness in the Foreign Exchange Market (FOREX) and is often referred to as Traded Weight Currency Index by FOREX traders. The Nominal Effective Exchange Rate (NEER) is not separately determined for each nation, this index simply shows the value of a domestic currency concerning multiple foreign currencies. Economies also adjust the NEER to control inflation in a nation. The NEER of currency appreciates when the value of the domestic currency increases concerning the other foreign currencies in the same regime, while when its value falls the NEER depreciates.

In the financial year, 2021-22 the Nominal Effective Exchange Rate (NEER) of India was around 93, while Real Effective Exchange Rate (REER) was 104.

What does the Nominal Effective Exchange Rate (NEER) indicate?

The NEER is simply a weight price index and can’t show whether a currency is getting stronger or weaker in real. The NEER simply represents a relative value that indicates the performance of a currency compared to other foreign currencies. However, NEER indicates the pace of growth of any currency concerning any other foreign currency. NEER  can be influenced by many factors, but majorly it’s influenced by the international trade of a nation. There are no standard baskets of currency that are being used to evaluate NEER, different organizations put different currencies in the basket. However, some of the major currencies in the world are US Dollar, British Pound, Euro, Japanese Yen, Canadian Dollar, Australian Dollar, and the Swiss Franc.

How is Nominal Effective Exchange Rate (NEER) Calculated?

The Nominal Effective Exchange Rate (NEER) is a weighted index that is calculated concerning a basket of foreign currency. The value of a foreign currency in a basket can be easily measured with an average of the total value of imports and exports between two nations. If the NEER coefficient is higher then it can be concluded that the domestic currency has a higher value than the compared foreign currency. But if the NEER coefficient is lesser, the domestic currency has a lesser value than the foreign currency in the basket. The NEER can be easily calculated with the below formula.

Calculation of Nominal Effective Exchange Rate (NEER) 

What is the Real Effective Exchange Rate (REER)?

Similar to the NEER, the Real Effective Exchange Rate (REER) is a weighted price index that shows the currency’s weighted average of major currencies in the basket. The REER indicates the competitiveness of the domestic currency with its major international trading currencies. REER can be simply determined by the relative trade balance of domestic currency with other currencies in the basket. An increase in REER indicates that a nation is losing its competitiveness in international trade as its exports become expensive while imports get cheaper. 

What does the Real Effective Exchange Rate (REER) indicate?

The REER indicates many things about a currency like its competitiveness in international trade, its trade capabilities, etc. The Real Effective Exchange Rate (REER) is quite helpful in a country’s trade flow and analyzing its impact on other factors. For example, if the INR exchange rate gets weaker against the USD, then America will get cheaper exports. If an individual consumer or a business in the US buys goods from India, then they need to convert their USD into INR. So if the INR is weaker than the USD, thus in such case Americans get more INR for each USD and resulting in the loss of the value of INR against the USD.

How is the Real Effective Exchange Rate (REER) calculated?

The REER can help analyze whether a country’s currency is overvalued, undervalued, or in equilibrium. If a country’s currency is in equilibrium, then it can be said that the total trade balances are equal i.e. total value of imports = total value of exports, and in such case a currency is stable. The REER can be simply calculated with the below formula.

Calculation of Real Effective Exchange Rate (REER)