# Effective exchange rate

Effective exchange rate |
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The **effective exchange rate** (EER) is a measure of a currency's relative strength against a basket of other currencies. It is composed of a weighted average of exchange rates, with weights corresponding to the importance of each currency in the country's foreign trade. In other words, the effective exchange rate reflects the external buying power of a currency and its strength in the global market.

The EER is calculated by summing up the products of the exchange rate and the trade weights of all the countries that the currency interacts with.

The effective exchange rate is a useful tool for measuring the relative strength of a currency against a basket of other currencies, and is therefore often used by governments, central banks, and commercial banks to assess the competitiveness of a currency. It can also be used to help determine the level of foreign reserves needed to maintain a currency's value, and to formulate exchange rate policy.

## Example of Effective exchange rate

Let's consider the example of the US Dollar. The US dollar has a basket of currencies it interacts with, such as the Euro, the British Pound, the Japanese Yen, and the Chinese Yuan. The following table shows the exchange rates of these four currencies against the US Dollar, along with their respective trade weights\[\begin{array}{|c|c|c|} \hline \text{Currency} & \text{Exchange Rate} & \text{Trade Weight} \\ \hline \text{Euro} & 0.9 & 0.29 \\ \hline \text{British Pound} & 0.8 & 0.23 \\ \hline \text{Japanese Yen} & 109 & 0.27 \\ \hline \text{Chinese Yuan} & 6.5 & 0.21 \\ \hline \end{array}\]

To calculate the effective exchange rate of the US Dollar against this basket of currencies, we can use the formula above. Therefore, the EER of the US Dollar can be calculated as follows:

<maht>\mathrm{EER} = 0.29 \cdot 0.9 + 0.23 \cdot 0.8 + 0.27 \cdot 109 + 0.21 \cdot 6.5 = 86.46</math>

This means that the US Dollar has an effective exchange rate of 86.46 against this basket of currencies.

In conclusion, the effective exchange rate is a useful measure for assessing the relative strength of a currency against a basket of other currencies. It is calculated by summing up the product of the exchange rate and the trade weights of all the countries that the currency interacts with. The resulting EER can be used to help determine foreign reserves and exchange rate policies.

## Formula of Effective exchange rate

The effective exchange rate (EER) is a measure of a currency's relative strength against a basket of other currencies. It is expressed mathematically as the sum of the products of the exchange rate and the trade weights of all the countries that the currency interacts with\[\mathrm{EER} = \sum_{i=1}^{n} w_i \cdot x_i \]

where:

- w
_{i}is the trade weight of country i - x
_{i}is the exchange rate of country i

By taking into account the importance of each currency in the country's foreign trade, the EER reflects the external buying power of a currency and its strength in the global market. It is a useful tool for assessing the competitiveness of a currency and can be used to help determine the level of foreign reserves needed to maintain a currency's value, and to formulate exchange rate policy.

## When to use Effective exchange rate

The effective exchange rate can be used in a variety of different circumstances:

- To evaluate a currency's competitiveness in the global market
- To determine the level of foreign reserves needed to maintain a currency's value
- To monitor volatility in currencies of countries that are important trading partners
- To formulate exchange rate policy

In conclusion, the effective exchange rate is a valuable tool that can be used to measure the relative strength of a currency against a basket of other currencies. It can be used to evaluate a currency's competitiveness in the global market, to determine the level of foreign reserves needed to maintain its value, to monitor volatility in currencies of important trading partners, and to help formulate exchange rate policy.

## Types of Effective exchange rate

**Nominal exchange rate**: This is the rate at which one currency can be exchanged for another.**Real exchange rate**: This exchange rate adjusts for relative price changes between countries.**Trade-weighted exchange rate**: This exchange rate takes into account the trade balance of a country and the relative importance of its trading partners.

The effective exchange rate is an important tool for understanding and assessing the relative strength of a currency against a basket of other currencies. By taking into account the trade weights and exchange rates of multiple countries, it provides a comprehensive measure of a currency's external buying power and its performance in the global market.

## Steps of Effective exchange rate

- Identify the currencies that are to be included in the index. The first step in calculating the effective exchange rate is to identify the currencies that will be included in the index. This typically includes currencies from the country's major trading partners, as these will likely have the greatest impact on the currency's external buying power.
- Determine the trade weights. The next step is to calculate the trade weights of each currency. This is done by taking the value of imports or exports of a given currency and dividing it by the total value of imports or exports for all currencies in the index.
- Calculate the exchange rate. The exchange rate of each currency is then calculated by taking the rate at which the currency can be exchanged for another currency in the index.
- Calculate the effective exchange rate. Finally, the effective exchange rate is calculated by multiplying the trade weight of each currency by its exchange rate and summing up the products.

## Advantages of Effective exchange rate

**Helps to measure the relative strength of a currency against a basket of other currencies**: The EER is a useful tool for measuring the relative strength of a currency against a basket of other currencies. This allows central banks and other monetary authorities to assess the competitiveness of their currency in the global market and compare it to other currencies.- Helps to determine the level of foreign reserves needed to maintain a currency's value: EER can also be used to help determine the level of foreign reserves needed to maintain a currency's value. This is because the EER reflects the external buying power of a currency and its strength in the global market.
**Aids in formulating exchange rate policy**: The EER can also be used to help formulate exchange rate policy, as it provides a comprehensive picture of a currency's strength in the global market.

## Limitations of Effective exchange rate

Despite its usefulness, the effective exchange rate also has several drawbacks.

- Firstly, the EER is heavily influenced by the exchange rates of the countries included in the basket, which can be difficult to accurately measure.
- Secondly, since the EER is based on a fixed basket of currencies, it does not accurately reflect changes in the relative importance of different currencies in the country's foreign trade.
- Finally, the EER does not take into account the different economic and political environments of the countries being measured, which can also have an impact on the relative strength of a currency.

There are a few approaches related to the effective exchange rate which are used to measure the external competitiveness of a currency. These include:

**Real Effective Exchange Rate (REER)**: This is a measure of the real exchange rate adjusted for changes in the relative price levels of the countries involved in the transaction.**Trade-weighted Exchange Rate (TWER)**: This approach uses trade weights based on the value of imports and exports of the currency in question.**Balance of Payments Exchange Rate (BEER)**: This approach uses balance of payments data to calculate the weights for the exchange rate.

Overall, the effective exchange rate is a useful tool for measuring the relative strength of a currency against a basket of other currencies, and is often used by governments, central banks, and commercial banks to assess the competitiveness of a currency. It can also be used to help determine the level of foreign reserves needed to maintain a currency's value, and to formulate exchange rate policy.

## Suggested literature

- Klau, M., & Fung, S. S. (2006).
*The new Bis effective exchange rate indices*. BIS Quarterly Review, March. - Dubas, J., Lee, B. J., & Mark, N. (2005).
*Effective exchange rate classifications and growth*.