NOMINAL AND REAL

EFFECTIVE EXCHANGE RATE

LEVERAGING FOREX MARKET FOR FINANCIAL

LEADERSHIP (SMMC862A)

INTERNATIONAL BUSINESS

DEEPANSHI AHUJA | 1902570010 | MBA 4th SEMESTER | EVALUATION-1

WHAT IS EFFECTIVE EXCHANGE RATE?
The effective exchange rate is the exchange rate of a monetary zone, measured as the
weighted sum of the exchange rates with trading partners and competitors. It measures the
value of the domestic currency against the weighted value of a basket of foreign currencies,
where the weights reflect the foreign countries' share in the domestic country's trade. In
simple words, it is an index that describes the strength of a currency relative to a basket of
other currencies.

Suppose a country has “N” trading partners and denote “Trade i” and “E1” as the trade and
exchange rate with country “i” respectively. Then the effective exchange rate is calculated
as:

The effective exchange rate is usually expressed as an index number out of 100. An increase
in the effective exchange rate indicates a strengthening of the home currency with respect
to other currencies considered in its calculation. Conversely, a decline in the effective
exchange rate means a weakening of the home currency.

WHAT IS NOMINAL EFFECTIVE EXCHANGE RATE?

The nominal effective exchange rate (NEER) is a form of measuring a currency’s nominal
exchange rate relative to a basket of other currencies using an unadjusted weighted-average
calculation. NEER is also sometimes referred to as the “trade-weighted currency index.”

The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at
which one country's currency exchanges for a basket of multiple foreign currencies. The
nominal exchange rate is the amount of domestic currency needed to purchase foreign
currency. The NEER may be adjusted to compensate for the inflation rate of the home
country relative to the inflation rate of its trading partners. The resulting figure is the real
effective exchange rate (REER). Unlike the relationships in a nominal exchange rate, NEER
is not determined for each currency separately. Instead, one individual number, typically
an index, expresses how a domestic currency’s value compares against multiple foreign
currencies at once.

If a domestic currency increases against a basket of other currencies inside a floating

exchange rate regime, NEER is said to appreciate. If the domestic currency falls against the
basket, the NEER depreciates.

The nominal exchange rate (NER) is the relative price of currencies of two countries. For
example, if the exchange rate is £ 1 = $ 2, then a British can exchange one pound for two

PAGE 1
dollars in the world market. Similarly, an American can exchange two dollars to get one
pound.

In order to determine the nominal effective exchange rate of a currency, the basket of
foreign currencies that it is being measured against must be determined. The basket is
chosen depending on the domestic country’s largest and most important trading partners,
as well as general major currencies. The world’s major currencies are as follows:

 U.S. dollar (USD)

 British pound (GBP)
 Japanese yen (JPY)
 Euro (EUR)
 Swiss franc (CHF)
 Chinese renminbi (CNH)
 Canadian dollar (CAD)
 Australian dollar (AUD)
 New Zealand dollar (NZD)
 South African rand (ZAR)

The basket of foreign currencies is weighted in accordance with the trading value relative
to the domestic currency. The value can be measured in export or import value, which
includes the total value of exports and imports in combination. It can also be measured in
other ways as well. The weights usually are related to the assets and liabilities of separate
countries.

WHAT IS REAL EFFECTIVE EXCHANGE RATE?

Real effective exchange rate is defined as “a weighted average of nominal exchange rates
adjusted for relative price differential between the domestic and foreign countries, relates
to the purchasing power parity (PPP) hypothesis". As the definition highlights, REER takes
price differential and inflation into account and, therefore, is said to be a better indicator of
the competitiveness of the country in terms of exchange rates.

The real effective exchange rate (REER) is the weighted average of a country's currency
in relation to an index or basket of other major currencies. The weights are determined by
comparing the relative trade balance of a country's currency against that of each country in
the index.

An increase in a nation's REER is an indication that its exports are becoming more expensive
and its imports are becoming cheaper. It is losing its trade competitiveness. A nation's
currency may be considered undervalued, overvalued, or in equilibrium with those of other
nations that it trades with. A state of equilibrium means that demand and supply are equally
balanced and prices will remain stable. A country's REER measures how well that

PAGE 2
equilibrium is being held. REER is determined by taking the average of the bilateral
exchange rates between one nation and its trading partners and then weighting it to take
into account the trade allocation of each partner.

 The real effective exchange rate (REER) compares a nation's currency value against
the weighted average of the currencies of its major trading partners.
 It is an indicator of the international competitiveness of a nation in comparison with
its trade partners.
 The formula is weighted to take into account the relative importance of each trading
partner to the home country.
 An increasing REER indicates that a country is losing its competitive edge.
 A nation's nominal effective exchange rate (NEER), adjusted for inflation in the
home country, equals its real effective exchange rate (REER).

MAJOR DIFFERENCE BETWEEN REAL AND NOMINAL EFFECTIVE

EXCHANGE RATE.
Nominal Effective Exchange Rate is the weighted average of bilateral nominal exchange
rates of the home currency in terms of foreign currencies. It is the exchange rate of one
currency against a basket of currencies, weighted according to trade with each country (not
adjusted for inflation).

 Real Effective Exchange Rate (REER) is the weighted average of nominal exchange
rates, adjusted for inflation.
 REER is calculated on the basis of NEER.
 REER captures inflation differentials between India and its major trading partners
and reflects the degree of external competitiveness of Indian products. It captures
movements in cross-currency exchange rates.

PAGE 3
HOW TO CALCULATE NEER AND REER?
The Nominal Effective Exchange Rate (NEER) can be calculated from the following
formula:

PAGE 4
The formula used for calculating Real Effective Exchange Rate (REER) is mentioned
below:

PAGE 5
RBI BULLETIN

USES OF REER AND NEER

 To know the external competitiveness
 To know the relative strength of the currency in terms of partner countries’
currencies
 To know whether the currency is strengthening or weakening relative to other
currencies
 To know how much a currency can purchase Useful researchers/economists/policy
makers/analysists.

-------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------

PAGE 6
PAGE 7