Effective Exchange Rate, Nominal Effective Exchange Rate (NEER) vs Real Effective Exchange Rate (REER), Overvaluation vs Undervaluation of Rupee

 

EFFECTIVE EXCHANGE RATE (EER):

• Effective Exchange Rate (EER) is an index that describes the relative strength of a currency relative to a basket of other currencies. 
• EER is an indicator of international Trade competitiveness.  
• EER can be either Real Effective Exchange Rate (REER) or Nominal Effective Exchange Rate (NEER).
•  Base year for calculating NEER and REER is shifted from 2004-05 to 2015-16.
• Both NEER and REER are calculated by Reserve Bank of India.

Nominal Exchange Rate (NER):

• Nominal Exchange Rate (NER) is the rate at which one currency will be exchanged for another foreign currency. 

• It is nothing but Exchange Rate.

Nominal Effective Exchange Rate (NEER):

• Nominal Effective Exchange Rate (NEER) is the unadjusted weighted average value of a country's currency relative to basket of currencies. 
• The weights of currencies are determined by weightage of trade done by the country in that currency, as measured by the Balance of Trade. 
• Nominal Effective Exchange Rate (NEER) focuses on the exchange of basket of currency.

Real Exchange Rate (RER) –

Real Exchange Rate (RER) is the value of currency wrt any foreign currency adjusted for the effects of inflation.

Real Effective Exchange Rate (RER) –

• Real Effective Exchange Rate (REER) is the weighted average of a country's currency relative to an index or basket of currencies adjusted for the effects of inflation. 
• Inflation component is measured in terms of CPI 
• The weights of currencies are determined by weightage of trade done by the country in that currency ,as measured by the Balance of Trade. 
• In India, Reserve Bank of India (RBI) compiles REER indices. 
• REER publishes two indices ie first one is based on six country’s trade-based weights and the second on 40-currencies’ export and trade-based weights. 
• The base year for calculating REER is taken as 100 and currently the base year is 2015-2016.

NEER vs REER: 

• Nominal Effective Exchange Rate (NEER) focuses on the exchange of currency while Real Effective Exchange Rate (REER) focuses on the exchange of goods and services.
• Increase in Real Effective Exchange Rate (REER) signifies appreciation of the Rupee and REER of more than 100 indicates that the rupee is overvalued.

 Overvaluation of the Rupee:

• Overvaluation of the rupee means that its price in terms of foreign currencies is too high ie appreciated.  
• Overvaluation of the Rupee makes our exports costly and our imports cheaper.

Undervaluation of the Rupee:

• Undervaluation of the rupee means its price in terms of foreign currencies is too low ie depreciated.
• Undervaluation of the Rupee is in favor of exports and against imports.