What Is the Real Effective Exchange Rate?
Understand how the real effective exchange rate measures a currency's true trade competitiveness by adjusting for inflation across trading partners.
Key Takeaways
- The real effective exchange rate (REER) adjusts the nominal exchange rate for relative inflation levels across trading partners.
- A rising REER indicates declining trade competitiveness, as domestic goods become relatively more expensive.
- REER is a more meaningful measure of currency valuation than the nominal exchange rate for assessing trade impacts.
What the REER Measures
The real effective exchange rate (REER) measures a currency's value against a weighted basket of trading partner currencies, adjusted for relative price levels. While the nominal exchange rate tells you how many units of one currency buy another, the REER reveals whether goods priced in the domestic currency are becoming more or less competitive internationally. If a country's inflation runs higher than its trading partners, the REER appreciates even if the nominal rate stays flat, signalling declining export competitiveness.
How the REER Is Calculated
The REER calculation involves three components. First, bilateral exchange rates between the domestic currency and each trading partner's currency are collected. Second, these rates are weighted by each partner's share of total trade. Third, the weighted average is adjusted for relative consumer price index or producer price index differentials. A REER index above 100 (using a base period) suggests the currency is relatively overvalued in real terms, while below 100 suggests undervaluation. The IMF, World Bank, and BIS all publish REER indices.
Why the REER Matters for Trade
A nominal depreciation does not necessarily improve competitiveness if domestic inflation offsets the currency decline. Consider a country whose currency depreciates 10% against the dollar, but domestic inflation runs 15% while US inflation is 3%. In real terms, the currency has actually appreciated, making the country's exports more expensive. The REER captures this dynamic, making it the preferred indicator for assessing whether a currency adjustment will genuinely boost trade. Policymakers monitor REER trends to evaluate exchange rate policy effectiveness.
REER Analysis for African Currencies
Many African currencies experience nominal depreciation alongside high domestic inflation, creating a divergence between nominal and real exchange rate trends. Nigeria's naira has depreciated substantially in nominal terms, but high domestic inflation has partially offset the competitiveness gains. Conversely, CFA franc zone countries with low inflation but a euro-pegged currency may see REER appreciation when the euro strengthens against other currencies. African businesses and policymakers benefit from monitoring REER trends to assess genuine trade competitiveness rather than relying solely on headline exchange rate movements.