What Is the Real Effective Exchange Rate (REER)?
The REER adjusts the exchange rate for inflation differences between countries. A better measure of competitiveness than the nominal rate.
Key Takeaways
- The nominal exchange rate is what you see on a currency screen
- The real exchange rate adjusts for inflation differences between countries
- REER measures a currency against a trade-weighted basket, adjusted for inflation
- A rising REER means exports are becoming less competitive even if the nominal rate is stable
Nominal vs real exchange rate
The exchange rate you see quoted — USD/GBP 1.27 — is the nominal exchange rate. The real exchange rate adjusts for the difference in price levels (inflation) between the two countries. If UK inflation is running at 5% and US inflation at 2%, the pound's purchasing power relative to the dollar is eroding even if the nominal rate is unchanged.
The real exchange rate formula
The real exchange rate equals the nominal exchange rate multiplied by the ratio of domestic prices to foreign prices. If nominal GBP/USD is 1.25, UK price level is 1.05 (5% inflation), and US price level is 1.02 (2% inflation), the real rate is 1.25 x (1.05/1.02) = 1.287. The real rate is higher than the nominal — meaning the pound buys less in real terms because UK prices have risen faster.
The effective rate
The Real Effective Exchange Rate (REER) measures a currency against a trade-weighted basket of trading partner currencies, each adjusted for relative inflation. A rising REER means UK exports are becoming more expensive for foreign buyers — a loss of competitiveness. A falling REER means UK exports are becoming relatively cheaper.
Why businesses should care
For exporters, REER trends matter more than nominal rate movements for long-term competitiveness. If UK inflation exceeds EU inflation while the nominal GBP/EUR rate is stable, UK goods are getting more expensive in real terms in EU markets. This explains why some UK manufacturers find it progressively harder to compete despite a nominally flat exchange rate.
Practical use
Use REER to contextualise long-term pricing strategy in export markets. If the UK REER has appreciated significantly against a major export market over several years, consider whether there is room to raise prices in local currency terms, or whether further efficiency improvements are needed to maintain margins.