Real Effective Exchange Rate (REER) - Indian Economy Notes
The Real Effective Exchange Rate (REER) is the nominal effective exchange rate (NEER) adjusted by relative prices or costs and is captured in inflation differentials between the home economy and trading partners. Effective exchange rates act as a means for assessing the fair value of a currency, the external competitiveness of an economy, and as guideposts for setting monetary and financial policies. In this article, we will discuss the nominal effective exchange rate (NEER) that is important for the UPSC examination.
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What is a Real effective exchange rate (REER)?
- REER is the weighted average of a country’s currency as compared to an index or basket of other major currencies.
- A comparison of the relative trade balance of a country’s currency against each country within the index tells about the weightage.
- This exchange rate is used to determine an individual country’s currency value relative to the other major currencies in the index.
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| Floating Exchange rate | Managed floating exchange rate |
| Nominal Exchange Rate | Nominal Effective Exchange Rate |
| Real Exchange Rate | Fixed Exchange Rate |
Real effective exchange rate (REER) - Overview
- The Reserve Bank of India compiles and disseminates the REER of the Indian rupee for both trades as well as export weight.
- Due to structural changes in the Indian economy, changes in macroeconomic and external sector performance, 2015-16 has been chosen as the new base year for the REER indices.
- Due to the increasing importance of emerging market and developing economies (EMDEs) in India’s foreign trade profile and also to reflect better shifts in external competitiveness, the coverage of the REER basket has been expanded from 36 to 40 currencies.
- The base year was chosen to be 2015-16, with real GDP growth at 8.0 percent, CPI inflation at 4.9 percent, and the current account deficit (CAD) at 1.1 percent of GDP.
- REER is an improvement over the NEER because it also takes into account the domestic inflation in the various economies.
- It is the weighted average of NEER, adjusted by the ratio of domestic prices to foreign prices.
- REER determines weights by comparing the relative trade balance of a country’s currency against each country within the index.
- It also serves as a useful tool for measuring the Marshall-Lerner condition to assess the efficacy of the exchange rate in correcting external trade imbalances.
Methodology for Calculation of REER
Where e: Exchange rate of Indian rupee against a numeraire, i.e., the IMF’s Special Drawing Rights (SDRs) in indexed form,
ei: Exchange rate of foreign currency ‘i’ against the numeraire (SDRs) (i.e., SDRs per currency i) in indexed form,
wi: Weights attached to foreign currency/country ‘i’ in the index
P: India’s wholesale price index (WPI), Pi: Consumer Price Index of Country I (CPIi), and
n: Number of countries/currencies in the index other than India.
- The REER of a country can be calculated by taking the average of its bilateral exchange rates with its trading partners and then weighing it using each partner's trade allocation.
- After assigning weights to each rate, the average of the exchange rates is calculated. For example, if a currency weights 60%, the exchange rate would be raised to the power of 0.60, and so on for each exchange rate and weighting.
- To create the scale or index, multiply the final result of each exchange rate in step 2 by 100.
- Some calculations use bilateral exchange rates, while others use real exchange rates, which account for inflation. REER is an average that is considered in equilibrium when it is overvalued about one trading partner and undervalued about a second trading partner, regardless of how it is calculated.
Recent Trends In REER
- For REER, inflation differentials during the period 2008-09 to 2014-15 have remained broadly stable in recent years, following a steady increase. This could be due to the formal adoption of the flexible inflation targeting (FIT) framework by the Reserve Bank in June 2016.
- Reduction in inflation may be due to price stability (due to a target of 4 percent for CPI headline inflation with a tolerance band of +/- 2 percent around it) while keeping in mind the objective of growth.
- Adoption of new REER indices has shown an increasing trend since 2004-05, indicative of India’s rising productivity vis-à-vis its trading partners.
- The below chart highlights the same.
Impact of REER
- An increasing trend in real exchange rate decreases the cost of imported capital goods and enhances the capital-labor ratio, thereby boosting technical progress and productivity.
- Appreciation of the real exchange rate can also lead to a rise in real wages thereby increasing labor productivity in a country where wages of unskilled laborers are generally low.
- Furthermore, the increase in the real exchange rate can also boost foreign competition, thereby leading to a rise in the technical efficiency and productivity of businesses.
Conclusion
Real Effective Exchange Rate (REER) captures the exchange rate with a greater degree of accuracy as compared to the nominal effective exchange rate (NEER). This happens because REER takes into account the domestic inflation in the various economies.
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| Indian Economy Notes | Indian Forex Reserves |
| Indian Foreign Exchange Market | Forex Related Terms |
FAQs
Question: What is the Real Effective Exchange Rate (REER)?
Answer: The Real Effective Exchange Rate (REER) is an index that measures the value of a country's currency relative to a basket of other major currencies, adjusted for inflation. It reflects the country's international competitiveness in terms of trade and indicates whether its currency is overvalued or undervalued compared to its trading partners.
Question: How is the REER different from the nominal exchange rate?
Answer: The nominal exchange rate is the unadjusted value of one currency relative to another, without accounting for price level differences or inflation. In contrast, the REER adjusts for inflation and changes in the relative prices of goods and services between countries, providing a more accurate measure of a country's trade competitiveness.
Question: What does an increase in the REER indicate?
Answer: An increase in the REER suggests that a country's currency has appreciated in real terms compared to its trading partners, potentially making its exports more expensive and imports cheaper. This can reduce the country's export competitiveness and lead to a trade deficit.
Question: Why is REER important for assessing a country's trade performance?
Answer: REER is important because it reflects the relative strength of a country's currency in terms of purchasing power and competitiveness in international trade. It helps policymakers, businesses, and investors assess trade performance, determine whether a currency is overvalued or undervalued, and make informed economic decisions.
Question: How does REER impact a country's economy?
Answer: REER affects a country's export and import competitiveness. A high REER indicates a strong currency, which may make exports less competitive and lead to higher imports, potentially resulting in trade deficits. Conversely, a lower REER makes exports more competitive, boosting trade surpluses and economic growth.
MCQs
- The Real Effective Exchange Rate (REER) measures a country's currency value:
A) Without considering inflation
B) Relative to a basket of other currencies, adjusted for inflation
C) Only against the US dollar
D) Based on domestic market fluctuations alone
Answer: (B) See the Explanation
REER is an index that adjusts the value of a country's currency relative to a weighted basket of currencies and considers inflation differences.
- An increase in the REER generally indicates that:
A) The country's exports have become more competitive
B) The country's currency has depreciated
C) The country's exports may become less competitive
D) The nominal exchange rate has remained constant
Answer: (C) See the Explanation
A higher REER indicates currency appreciation, making exports more expensive for trading partners.
- REER differs from the nominal exchange rate because it:
A) Ignores inflation differences
B) Considers inflation and price changes across countries
C) Focuses only on a single trading partner
D) Measures only currency depreciation
Answer: (B) See the Explanation
REER adjusts for relative inflation and changes in the purchasing power of currencies.
- A decrease in the REER value implies:
A) The country's currency has become more competitive internationally
B) Increased import costs
C) No change in export competitiveness
D) A stronger currency relative to other nations
Answer: (A) See the Explanation
A lower REER value indicates depreciation of the currency, potentially boosting export competitiveness.
- The main purpose of calculating the REER is to:
A) Measure inflation rates
B) Assess a country's trade competitiveness
C) Track daily currency exchanges
D) Determine GDP growth rates
Answer: (B) See the Explanation
REER helps evaluate a country's international trade competitiveness by considering currency value relative to trading partners.
GS Mains Questions and Model Answers
Q1: Explain the significance of the Real Effective Exchange Rate (REER) in evaluating a country's trade competitiveness and economic policies.
Answer: The Real Effective Exchange Rate (REER) is a key indicator used to measure a country's currency value relative to a basket of major currencies, adjusted for inflation differences. It reflects the competitiveness of a country's goods and services in international markets. A higher REER indicates an appreciating currency, making exports relatively expensive and imports cheaper, potentially leading to trade deficits. Conversely, a lower REER signals a depreciated currency, boosting export competitiveness. Policymakers use REER to assess the impact of exchange rate policies, trade competitiveness, and overall economic health, guiding decisions on monetary and fiscal policies to maintain economic stability.
Q2: Discuss how fluctuations in the REER impact a country's exports, imports, and overall balance of trade.
Answer: Fluctuations in the Real Effective Exchange Rate (REER) directly impact a country's export and import dynamics. An increase in the REER indicates a real appreciation of the currency, making exports more expensive and less competitive in international markets, while imports become cheaper. This can lead to a reduction in export revenue and an increase in import expenses, potentially causing a trade deficit. Conversely, a decrease in the REER signals a depreciation of the currency, enhancing export competitiveness and discouraging imports, which may lead to a trade surplus. Managing REER fluctuations is crucial for maintaining trade balance and economic stability.
Q3: Analyze the factors influencing the Real Effective Exchange Rate (REER) and their implications for economic policy.
Answer: Several factors influence the Real Effective Exchange Rate (REER), including inflation differentials, changes in nominal exchange rates, trade policies, and global economic conditions. Inflation differences between a country and its trading partners impact relative prices, affecting the REER. Exchange rate fluctuations due to market forces, monetary policy decisions, and trade tariffs can also alter the REER. Policymakers must consider these factors when formulating economic policies to maintain a competitive currency value, stabilize trade flows, and manage inflation. Effective REER management supports economic growth, balanced trade, and international competitiveness.
Previous Year Questions on Real Effective Exchange Rate (REER)
1. UPSC CSE 2020
Question: Evaluate the role of the Real Effective Exchange Rate (REER) in determining a country's international trade competitiveness.
Answer: The Real Effective Exchange Rate (REER) plays a crucial role in determining a country's trade competitiveness by measuring its currency value relative to a basket of other currencies, adjusted for inflation. A higher REER indicates that a country's currency has appreciated, potentially reducing export competitiveness due to higher relative prices of its goods and services. Conversely, a lower REER suggests a depreciated currency, enhancing export competitiveness and reducing the cost of imports for trading partners. Policymakers use REER to assess and guide economic policies aimed at maintaining a balanced trade position, addressing inflationary pressures, and fostering international competitiveness.
2. UPSC CSE 2019
Question: Discuss the impact of a fluctuating REER on a developing country's economic stability and trade performance.
Answer: Fluctuations in the Real Effective Exchange Rate (REER) can significantly impact a developing country's economic stability and trade performance. An appreciating REER may reduce export competitiveness, leading to lower export revenues and potential trade deficits, affecting economic growth. On the other hand, a depreciating REER can enhance export competitiveness, boost foreign exchange earnings, and improve the trade balance. However, it may also lead to higher import costs and inflationary pressures. Managing REER fluctuations requires sound monetary, fiscal, and trade policies to stabilize the economy, foster balanced trade, and ensure long-term economic growth.
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