What is the 'Real Effective Exchange Rate - REER'
The real effective exchange rate (REER) is the weighted average of a country's currency relative to an index or basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index. This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, such as the U.S. dollar, Japanese yen and the euro.
BREAKING DOWN 'Real Effective Exchange Rate - REER'
The REER is used to measure the value of a specific currency in relation to an average group of major currencies. The REER takes into account any changes in relative prices and shows what can actually be purchased with a currency. This means that the REER is normally trade-weighted.
The REER is derived by taking a country's nominal effective exchange rate (NEER) and adjusting it to include price indices and other trends. The REER, then, is essentially a country's NEER after removing price inflation or labor cost inflation. The REER represents the value that an individual consumer pays for an imported good at the consumer level. This rate includes any tariffs and transaction costs associated with importing the good.
A country's REER can also be derived by taking the average of the bilateral real exchange rates (RER) between itself and its trading partners and then weight it using the trade allocation of each partner. Regardless of the way in which REER is calculated, it is an average and considered in equilibrium when it is overvalued in relation to one trading partner and undervalued in relation to a second partner.
Benefits of Analyzing and Using the REER
A country's REER is an important measure when assessing its trade capabilities and current import/export situation. The REER can be used to measure the equilibrium value of a country's currency, identify the underlying factors of a country's trade flow, look at any changes in international price or cost competition, and allocate incentives between tradable and non-tradable sectors.
A country can positively affect its REER through rapid productivity growth. When this happens, the country realizes lower costs and can reduce prices, thus making the REER more advantageous for the country.
Understanding a country's REER is extremely important when conducting economic analysis and policymaking. Therefore, the World Bank, the Eurostat, the Bank for International Settlements (BIS) and others all publish various REER indicators. These world institutions combine to provide the public with REER analysis on 113 countries around the globe.