Analysis of REER and its correlation to NEER and Trade

As per RBI methodology, Exchange rate of Indian INR wrt $ is :

If 1 $=80 Rs ,then RBI calculates it as 1 INR =1/80 $ ie .0125 $/INR.

                      REER = NEER *Domestic Price/Foreign price

REER of INR vs U.S. $ = (Indian prices / US Prices in $)*Exchange rate of the INR vs. US $ * 100

*****Exchange Rate is as per RBI methodology ie 1 INR =1/80 $ ie .0125 $/INR and not 1 $=80 INR.

SIGNIFICANCE OF REER:

• REER focuses on the exchange of goods and services. 
• Increase in REER exchange rate means inflation is increasing.
• If a countries real exchange rate is rising it means its goods are becoming more expensive  relative to its competitors.

IMPACT OF CHANGES IN NEER UPON REER:

If prices in India and US remain constant and there is only change in NEER:

Assuming 1 INR =1/80 $ ie .0125 $/INR as basis for all calculations:

1.If INR appreciates then 1$=50 Rs ie .02 $/INR,

•                                                   then NEER will appreciate 
•                                                   and hence REER will also appreciate and 
•                                                    it will be non Trade-competitive .

2. If INR depreciates then 1$=100 Rs ie .001 $/INR,

•                                                then NEER will depreciate 
•                                                and REER will also depreciate 
•                                                and it will be Trade - competitive.

Analysis:

Assuming Exchange rate to remain constant,

1.If prices in the two countries are the same, then the REER is 100.

2. If Indian domestic prices are higher than US  prices, then REER > 100.

3.If U.S. prices are higher than Indian prices, the REER < 100.

If the REER > 100:

• Domestic prices are relatively high and hence domestic products are non-Trade competitive. 
• Domestic currency is overvalued. 
• In this case there is more imports in comparison to Exports, leading to widening of the Current Account Deficit (CAD).

If the REER < 100: 

• Domestic prices are relatively low and hence domestic products are trade competitive. 
• Domestic currency is Under-valued.
• In this case there is more exports in comparison to imports, leading to lowering of the Current Account Deficit (CAD).

Conclusively REER is:

•                                             Directly proportional to Domestic Prices 
•                                             Inversely proportional to Foreign prices 
•                                             Inversely proportional to Trade competitiveness.