Effective exchange rate

Effective exchange rate is an index measuring the value of a currency against a weighted basket of foreign currencies, providing a comprehensive view of a country's external competitiveness. Unlike bilateral exchange rates that compare two currencies directly, effective rates capture overall currency strength across multiple trading partners. The Bank for International Settlements (BIS) and International Monetary Fund (IMF) publish these indices for approximately 60 and 90 countries respectively.

Types of effective exchange rates

Nominal effective exchange rate (NEER)

The NEER measures currency movements against a basket of partner currencies using trade weights.^[1] It is calculated as a geometric weighted average of bilateral nominal exchange rates. A rise in the NEER indicates currency appreciation against trading partners.

The formula takes the form:

NEER = Product of (bilateral exchange rate)^(trade weight)

Trade weights typically derive from bilateral import and export flows. The BIS updates weights every three years to reflect changing trade patterns. This adjustment matters because emerging economies have grown substantially in global trade since 2000.

The NEER cannot determine absolute currency strength. It only indicates whether a currency is strengthening or weakening relative to its historical values. Two countries might both report rising NEERs if each appreciates against different partners.

Real effective exchange rate (REER)

The REER adjusts the NEER for relative price levels between the home country and trading partners. This measure better reflects international competitiveness because it accounts for inflation differentials.

The calculation divides the NEER by the ratio of domestic to foreign price indices:

REER = NEER x (Foreign price level / Domestic price level)

Consumer price indices are most commonly used for deflation, though producer prices and unit labor costs serve as alternatives. Each choice emphasizes different competitiveness aspects. Unit labor costs highlight manufacturing sector competitiveness specifically.

An increase in the REER signals declining competitiveness. Exports become relatively more expensive for foreign buyers, while imports become cheaper for domestic consumers. Persistent REER appreciation may indicate overvaluation requiring eventual correction.

Calculation methodology

Weight determination

The BIS employs double-weighting to capture both bilateral trade and third-market competition. Consider three countries: if Country A and Country B both export to Country C, changes in their bilateral exchange rate affect competitiveness in Country C's market even if A and B trade little directly.

The IMF uses a similar approach for its indices published monthly. Eurostat calculates effective rates for EU member states using harmonized methodology. Each organization makes slightly different methodological choices, so indices may not be directly comparable.

Index construction

Effective rate indices use geometric averaging because percentage changes aggregate properly. A base year normalizes the index to 100. The BIS uses 2020 as its current base year. Historical comparisons require consistent methodology across the entire series.

Time-varying weights introduce chain-linking complications. The BIS assigns three-year average weights to corresponding periods and constructs chain-linked indices. This approach prevents abrupt jumps when weights update.

Applications and interpretation

Competitiveness assessment

Policymakers monitor REER movements as competitiveness indicators. The European Commission publishes quarterly REER data for all EU members. Sustained appreciation may signal adjustment needs. Greece experienced significant REER appreciation between 2001 and 2009, contributing to current account imbalances that became acute during the sovereign debt crisis.

Monetary policy

Central banks incorporate effective rates into monetary conditions indices. A 10% effective appreciation might tighten monetary conditions as much as several interest rate increases. The Reserve Bank of New Zealand pioneered explicit exchange rate targeting through its Monetary Conditions Index in the 1990s.

Trade flow analysis

Economists use effective rates to estimate trade elasticities. A REER depreciation should boost export volumes and reduce imports. However, pass-through from exchange rates to trade flows varies by country and product category. The J-curve effect describes how trade balances initially worsen after depreciation before improving.

Limitations

Effective exchange rates face several criticisms. Weight determination involves arbitrary choices about trading partner selection and time periods. Prices indices imperfectly capture quality changes in traded goods. Monthly or quarterly frequency misses short-term currency volatility that affects business decisions.

The indices assume price-taking behavior in international markets. Large economies may set rather than take prices, making standard competitiveness interpretations problematic. China's export success occurred despite periods of REER appreciation because productivity gains exceeded exchange rate effects.

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References

• Bank for International Settlements (2024). "Effective Exchange Rates." BIS Statistics.
• International Monetary Fund (2023). International Financial Statistics Yearbook. Washington DC: IMF.
• Klau, M. & Fung, S.S. (2006). "The New BIS Effective Exchange Rate Indices." BIS Quarterly Review, March 2006.
• Eurostat (2024). Effective Exchange Rates - Methodological Note. European Commission.

Footnotes

[1] The IMF began publishing NEER and REER indices in the 1970s, expanding coverage as more countries adopted floating exchange rates following the collapse of the Bretton Woods system in 1971-1973.