The Real Effective Exchange Rate (REER) is a weighted average of a country’s currency in relation to a basket of other major currencies. The weights are based on the relative trade balance of a country’s currency against each country in the index.
An increase in a nation’s REER indicates that its exports are becoming more expensive and its imports are becoming cheaper, leading to a loss in trade competitiveness.
Key Takeaways:
- REER compares a nation’s currency value against the weighted average of currencies of its major trading partners.
- It measures international competitiveness.
- The formula is weighted to reflect the trade importance of each partner.
- An increasing REER suggests a loss of competitive edge.
- REER is the nominal effective exchange rate (NEER) adjusted for home country inflation.
How to Calculate the Real Effective Exchange Rate (REER)
The REER measures how well a country maintains trade equilibrium, where demand and supply are balanced, and prices remain stable. It is calculated by taking the average of bilateral exchange rates between a nation and its trading partners, weighted by trade allocation.
Formula for REER:
What Does REER Tell You?
REER is crucial for assessing a country’s trade capabilities. It can:
- Measure the equilibrium value of a country’s currency.
- Identify factors affecting trade flow.
- Analyze impacts of competition and technological changes on trade.
For instance, if the U.S. dollar weakens against the euro, U.S. exports to Europe become cheaper, increasing competitiveness. The euro’s weight in the index means its exchange rate changes have a significant impact on REER.
Example of REER Calculation
Assume the U.S. trades with only three parties: the eurozone, Great Britain, and Australia. The trade weights are:
- Eurozone: 70%
- Great Britain: 20%
- Australia: 10%
In this case, the euro’s exchange rate changes have a greater impact on REER than the Australian dollar’s rate changes.
REER vs. Spot Exchange Rate
The spot exchange rate is the current price to exchange one currency for another for the earliest possible value date. In contrast, REER is an indicator of a currency’s value relative to its trading partners over time.
Roger Varley is a seasoned financial expert with over two decades of experience and an MBA from Harvard Business School. He specializes in commodity trading and portfolio diversification, and has authored several bestsellers that simplify complex financial concepts for investors. Residing in New York City, Roger continues to share his knowledge through his writing and lectures at financial conferences worldwide.
