Real Effective Exchange Rate

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 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.

Breaking down the formula: The average of the exchange rates is calculated after assigning the weightings for each rate. For example, if a currency had a 60% weighting, the exchange rate would be raised to the power by 0.60. The same is done for each exchange rate and its respective weighting. Multiply all of the exchange rates. Then multiply the final result by 100 to create the scale or index.

Some calculations use bilateral exchange rates while other models use real exchange rates. The latter adjusts the exchange rate for inflation.

Regardless of the way in which REER is calculated, it is an average that indicates when a currency is overvalued in relation to one trading partner or undervalued in relation to another partner.

A country’s REER is an important measure when assessing its trade capabilities. REER can be used to measure the equilibrium value of a country›s currency, identify the underlying factors of a country›s trade flow, and analyze the impact that other factors, such as competition and technological changes, have on a country and ultimately on the trade-weighted index.

For example, if the US dollar exchange rate weakens against the euro, US exports to Europe will become cheaper. European businesses or consumers buying US goods need to convert their euros to dollars to buy our exports. If the dollar is weaker than the euro, it means Europeans can get more dollars for each euro. As a result, US goods get cheaper due solely to the exchange rate between the euro and the US dollar.

The US has a substantial trading relationship with Europe. Because of this, the euro to US dollar exchange would have a larger weighting in the index. A big move in the euro exchange rate would impact the REER more than if another currency with a smaller weighting strengthened or weakened against the dollar.

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