Real Effective Exchange Rate Model

The REER Model, or Real Effective Exchange Rate Model, is an economic tool used to measure and analyse the value of a country’s currency relative to the currencies of its major trading partners, adjusted for inflation differentials. The Real Effective Exchange Rate (REER) serves as an indicator of a country’s international competitiveness, reflecting changes in exchange rates and price levels across nations. It is widely employed in macroeconomic analysis, policy formulation, and exchange rate management to assess whether a currency is overvalued or undervalued in real terms.

Concept and Definition

The Real Effective Exchange Rate (REER) represents the weighted average of a country’s real exchange rates with its key trading partners. It adjusts the Nominal Effective Exchange Rate (NEER)—which is the trade-weighted average of bilateral nominal exchange rates—by considering relative price levels or inflation rates between the home country and its partners.
Mathematically, REER can be expressed as:
REER=NEER×P∗P\text{REER} = \text{NEER} \times \frac{P^*}{P}REER=NEER×PP∗​
Where:

• NEER = Nominal Effective Exchange Rate (weighted average of bilateral exchange rates)
• P* = Weighted foreign price level (inflation of trading partners)
• P = Domestic price level (inflation in the home country)

A rise in REER indicates that domestic goods have become relatively expensive, suggesting a loss of competitiveness, while a decline in REER implies improved competitiveness through lower relative prices.

Understanding NEER and REER

To comprehend the REER model, it is essential to distinguish between NEER and REER:

• Nominal Effective Exchange Rate (NEER): Measures the unadjusted (nominal) value of a currency relative to a basket of other currencies based on trade weights.
• Real Effective Exchange Rate (REER): Adjusts NEER for inflation differences, giving a “real” measure of exchange rate movement and purchasing power parity.

For instance, if India’s NEER depreciates by 5% but inflation in India is 7% while its trading partners’ average inflation is 3%, the REER may actually appreciate, indicating reduced competitiveness despite nominal depreciation.

Objectives of the REER Model

The main objectives of constructing and analysing the REER Model are:

• To measure international competitiveness of a country’s goods and services.
• To evaluate the sustainability of the exchange rate.
• To assess external balance and current account trends.
• To inform monetary and exchange rate policies.
• To compare real exchange rate movements across time or economies.

Construction of the REER Index

The construction of the REER involves a series of steps:

1. Selection of Trading Partners: Major trading partners are identified based on their share in the country’s total trade (exports and imports).
2. Assignment of Trade Weights: Each partner is assigned a weight corresponding to its share in total trade.
3. Computation of Bilateral Nominal Exchange Rates: The exchange rates between the domestic currency and each partner’s currency are compiled.
4. Calculation of NEER: The nominal effective exchange rate is calculated as a weighted average of the bilateral rates.
5. Adjustment for Relative Prices: Inflation or price indices (such as Consumer Price Index – CPI, Wholesale Price Index – WPI, or GDP Deflator) are used to adjust for inflation differentials, leading to the REER value.
6. Indexing and Normalisation: The REER is generally expressed as an index with a base year (e.g., 2015–16 = 100) for comparison over time.

Interpretation of REER

• REER > 100: Indicates currency appreciation in real terms (loss of competitiveness).
• REER < 100: Indicates currency depreciation in real terms (gain in competitiveness).
• Stable REER: Suggests balanced competitiveness with external price stability.

A persistently high REER may discourage exports and encourage imports, leading to trade deficits, while a low REER may boost exports but cause import inflation.

REER and Economic Policy

Central banks and policymakers use the REER Model as a tool for macroeconomic management and exchange rate policy formulation.
1. Monetary Policy:

• Helps assess whether currency movements are inflationary or deflationary.
• Guides interest rate decisions to stabilise exchange rates and prices.

2. Fiscal and Trade Policy:

• Informs export and import competitiveness analysis.
• Assists in evaluating tariff and subsidy impacts on external trade.

3. Balance of Payments Management:

• REER helps monitor current account balances and capital flows.
• Persistent REER misalignment can indicate external sector vulnerabilities.

4. Exchange Rate Regime Assessment:

• Enables evaluation of whether the existing exchange rate policy (fixed, floating, or managed) supports external equilibrium.

REER in the Indian Context

In India, the Reserve Bank of India (RBI) computes and publishes both the Nominal Effective Exchange Rate (NEER) and the Real Effective Exchange Rate (REER) indices for different baskets of currencies (6-currency and 40-currency baskets).

• The 6-currency REER covers India’s major trading partners, including the US, Eurozone, UK, Japan, China, and Hong Kong.
• The 40-currency REER provides a broader measure of competitiveness reflecting India’s diversified trade relations.

The RBI uses the Consumer Price Index (CPI) as the deflator for constructing REER. Movements in the index are used to assess whether the Indian rupee is overvalued or undervalued in real terms.
For example:

• A rise in India’s REER indicates rupee appreciation, suggesting declining export competitiveness.
• A fall in REER implies rupee depreciation, making exports more competitive but potentially increasing import costs.

Factors Affecting REER

Several factors influence the movements of the Real Effective Exchange Rate:

• Inflation differentials between the domestic economy and its trading partners.
• Nominal exchange rate fluctuations due to market forces or central bank intervention.
• Trade policy changes such as tariffs, subsidies, or quotas.
• Terms of trade—the relative prices of exports and imports.
• Capital flows and foreign investment trends.
• Productivity differentials across countries.

Advantages of the REER Model

• Provides a comprehensive measure of competitiveness rather than relying on bilateral exchange rates.
• Helps identify currency misalignment and external sector imbalances.
• Useful for long-term economic analysis and policy formulation.
• Facilitates international comparison of exchange rate dynamics.
• Assists exporters and investors in making informed decisions.

Limitations of the REER Model

Despite its wide usage, the REER model has some limitations:

• Choice of price index (CPI, WPI, or GDP deflator) can affect outcomes.
• Trade weights may become outdated with changing trade patterns.
• Non-tradable goods and services are not adequately captured.
• Short-term capital flows and speculation can distort exchange rates.
• Data quality issues in developing economies can affect reliability.

Policy Implications

REER analysis helps policymakers and central banks:

• Determine if the currency is fundamentally misaligned with economic fundamentals.
• Adjust monetary policy stance to correct overvaluation or undervaluation.
• Formulate strategies for export promotion and import management.
• Maintain external sector stability and prevent balance of payments crises.