What Is the Real Effective Exchange Rate (REER) and Its Equation? (2024)

What Is the Real Effective Exchange Rate (REER)?

The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against that of each country in the index.

An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper, reducing its trade competitiveness.

How to Calculate the Real Effective Exchange Rate (REER)

A nation's currency may be considered undervalued, overvalued, or in equilibrium with those of other nations that it trades with. A state of equilibrium means that demand and supply are equally balanced and prices will remain stable.

A country's REER measures how well that equilibrium is being held.

REER is determined by taking the average of the bilateral exchange rates between one nation and its trading partners and then weighting it to take into account the trade allocation of each partner.

The Formula for REER Is

$\begin{aligned} &\text{REER}=\text{CER}^n\times\text{CER}^n\times\text{CER}^n\times100\\ &\textbf{where:}\\ &\text{CER = Country exchange rate}\\ \end{aligned}$​REER=CERn×CERn×CERn×100where:CER=Countryexchangerate​

Breaking down the formula:

• The average of the exchange rates is calculated after assigning the weightings for each rate. For example, if a currency had a 60% weighting, the exchange rate would be raised to the power by 0.60. The same is done for each exchange rate and its respective weighting.
• Multiply all of the exchange rates.
• Then multiply the final result by 100 to create the scale or index.

Some calculations use bilateral exchange rates while other models use real exchange rates. The latter adjusts the exchange rate for inflation.

Regardless of the way in which REER is calculated, it is an average that indicates when a currency is overvalued in relation to one trading partner or undervalued in relation to another partner.

What Does the REER Tell You?

A country's REER is an important measure when assessing its trade capabilities.

REER can be used to measure the equilibrium value of a country's currency, identify the underlying factors of a country's trade flow, and analyze the impact that other factors, such as competition and technological changes, have on a country and ultimately on the trade-weighted index.

For example, if the U.S. dollar exchange rate weakens against the euro, U.S. exports to Europe will become cheaper. European businesses or consumers buying U.S. goods need to convert their euros to dollars to buy our exports. If the dollar is weaker than the euro, it means Europeans can get more dollars for each euro. As a result, U.S. goods get cheaper due solely to the exchange rate between the euro and the U.S. dollar.

The U.S. has a substantial trading relationship with Europe. Because of this, the euro to U.S. dollar exchange would have a larger weighting in the index. A big move in the euro exchange rate would impact the REER more than if another currency with a smaller weighting strengthened or weakened against the dollar.

Example of REER

Let's say the U.S. had a foreign trading relationship with only three parties: the eurozone, Great Britain, and Australia. That means the U.S. dollar has a trading relationship with the euro, the British pound, and the Australian dollar.

In this hypothetical example, the U.S. does 70% of its trading with the eurozone, 20% with Great Britain, and 10% with Australia. The basket of currencies in this case would also hold the same percentages, with the euro at 70%, the British pound at 20%, and the Australian dollar at 20%.

A move in the euro would have a greater impact on the basket than a move in the Australian dollar. If one of the exchange rates moved significantly but the weighted average of the basket didn't change, it could mean that the other currencies moved in the opposite direction, offsetting the move of the first currency.

REER vs. Spot Exchange Rate

A spot exchange rate is the current price to exchange one currency for another for delivery on the earliest possible value date. (Thevalue date is the effective date for a financial transaction involving an asset that fluctuates in price.)

Although the spot exchange rate is for delivery on the earliestdate, the standardsettlement datefor most spot transactions is two business days after the transaction date.

The spot exchange rate, therefore, is a current market price. The REER is an indicator of the value of a currency in relation to its trading partners.

Limitations of the REER

Factors besides trade can impact the REER. The real effective exchange rate doesn't take into account price changes, tariffs, or other factors that may affect trade between nations. If prices are higher in one country compared with another, the trade might decrease in the country with higher prices, impacting its REER. The weighting used in the REER calculation then has to be adjusted to reflect any changes in trade.

In addition, the central bank of each nation adjusts its monetary policy, which can lower or raise interest rates in the home country. The flow of money could increase to countries with higher rates as investors chase yield, thus strengthening the currency exchange rate. The REER would be impacted, but it would have little to do with trade and more to do with the interest rate markets.

The Bottom Line

The real effective exchange rate (REER) is a measure of the relative strength of a nation's currency in comparison with those of the nations it trades with. It is used to judge whether the nation's currency is undervalued, overvalued, or fairly valued.