Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER)

Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER)

The concepts of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) extend the ideas of nominal and real exchange rates from bilateral (one-to-one) to multilateral (one-to-many) contexts. These rates are particularly useful for assessing a country’s overall external competitiveness.

Nominal Effective Exchange Rate (NEER)

NEER is an index that measures the value of a country’s currency relative to a basket of several foreign currencies. It is a weighted average of bilateral nominal exchange rates. The weights typically reflect the relative trade importance of the countries whose currencies are included in the basket.

Example:

Imagine a country, Country A, that trades primarily with three countries: B, C, and D. The trade weights based on the importance are as follows: B (50%), C (30%), and D (20%). Let’s say the nominal exchange rates are:

• A to B: 1 A = 2 B
• A to C: 1 A = 0.5 C
• A to D: 1 A = 1 D

The NEER for Country A can be calculated as a weighted average:

NEER = (2 x 0.5) + (0.5 x 0.3) + (1 x 0.2) = 1 + 0.15 + 0.2 = 1.35

This index value (1.35) indicates the average value of Country A’s currency relative to its trading partners’ currencies.

Real Effective Exchange Rate (REER)

REER adjusts NEER for inflation or price level differences between the home country and its trading partners. It provides a measure of a country’s competitiveness in terms of prices. A higher REER indicates that a country’s goods are more expensive relative to its trading partners, potentially reducing competitiveness.

Example:

Continuing with the previous example, let’s incorporate inflation rates to calculate REER. Assume the inflation rates over a specific period are as follows: Country A (2%), Country B (4%), Country C (1%), and Country D (3%).

To adjust for inflation, we could use the formula:

REER = NEER x (Domestic Price Level / Foreign Price Level)

For simplicity, let’s say the adjusted REER calculation, considering inflation, results in a value of 1.25. This adjusted figure reflects the real value of Country A’s currency against its trading partners, considering both exchange rates and price levels.

Key Differences

NEER is a weighted average of nominal exchange rates between a country’s currency and a basket of foreign currencies, reflecting the country’s external competitiveness without adjusting for price levels.

REER further adjusts NEER for inflation or price levels, offering a more accurate measure of a country’s competitiveness in terms of real prices.

Both NEER and REER are crucial for economic analysis, policy formulation, and understanding the broader implications of exchange rate movements on a country’s economy. They help policymakers and analysts assess the impact of exchange rate changes on trade balance, inflation, and economic performance.