Real Effective Exchange Rate (REER)
Candlefocus EditorThe REER is often used as a tool by economists to measure the economic performance of a country in international trade. It is particularly relevant for countries with large trade imbalances or volatile exchange rates, as it provides a better insight into the effects of exchange rate fluctuations on a country’s economy. It helps to keep track of the nations’ purchasing power parity, as well as their terms of trade.
To calculate the real effective exchange rate, the nominal exchange rate of each country from its trading partners is adjusted to reflect the differences in inflation rates between the home country and the trading partners. These rates are then combined into a single Exchange Rate Index (ERI) to show how competitive a country is compared to its trading partners.
A rising REER suggests that a country's trading partners' currencies have appreciated against its own, making its exports less competitive in foreign markets. It also indicates that foreign imports are becoming more expensive in terms of the home currency, which can have a negative impact on consumer spending. A falling REER indicates a competitive advantage for the home country's exports, and cheap imports from abroad.
REER can be used as a policy tool by central banks and governments. A rising REER can be addressed by cutting interest rates, as this makes domestic investment and spending more attractive for foreign investors, and vice versa. Policy makers can also make use of fiscal policy measures to control REER, such as direct control over exchange rates, adjustment of fiscal policies, encouraging policy reforms, implementing tariffs, and other restrictions on free trade.
In conclusion, the real effective exchange rate (REER) is an important tool used to compare a country’s exchange rate with that of its trading partners, and to measure its international competitiveness. By tracking the REER, policy makers are better able to understand the implications of exchange rate fluctuations on their country's economy, and can take appropriate measures to ensure their country remains competitive in international markets.