Before we move on to Real Effective Exchange Rate (REER), let’s understand what is meaning of exchange rate.
Exchange rate indices measures the value of a currency vis-à-vis other currencies. Fluctuation in exchange rate also affects the price level of goods.
Mainly two types of exchange rate indices are:
- NEER (Nominal Effective Exchange Rate)
- REER (Real Effective Exchange Rate)
NEER (Nominal Effective Exchange Rate)
A NEER is the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in either the country’s international trade or payments
REER (Real Effective Exchange Rate)
Real Effective Exchange Rate (REER) is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs. It measures the value of a currency against a basket of other currencies; it takes into account changes in relative prices and shows what can actually be bought.
An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.
REER is calculated by multiplying NEER with the effective relative price indices of trading partners.
The REER index indicates that, if the relative inflation in one country ( in comparison to inflation level in other countries ) is same, then REER is 100 and the exchange rate is governed by the comparative inflation rate.
- If the REER is > 100, then the INR is “overvalued” and is expected to depreciate.
- If REER < 100, the INR is “undervalued” and is expected to appreciate in future
In 2005, RBI reduced the trading partner’s currency to six. The six-currency indices include U.S.A, Eurozone, U.K., Japan, China and Hong Kong SAR.
Exchange Rate Pass Through
Exchange rate pass through measure the percentage change in domestic prices of goods resulting from one percentage change in the exchange rate. If 1 percentage change in exchange rate results in 1 percentage change in domestic goods prices, then pass through is 100% or a complete pass through. Less than one-to-one change in domestic price compared to exchange rate is an incomplete or partial pass through.
Effect of change in exchange rate on foreign trade
- If the domestic currency depreciates or devalued against foreign currency, the imported goods become costlier therefore there is tendency to decrease import whereas exported goods fetch more money, thus export tends to rise.
- If the domestic currency appreciates or revalued against foreign currency, the imported goods become cheaper therefore there is tendency to increase import whereas exported goods fetch less money, thus export tends to decrease.
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