Effective exchange rate

From Hobson's Choice

The effective exchange rate for a particular currency represents its exchange value against a weighted group of other currencies. THe group is usually weighted for trade with the country issuing the currency.

1 Context
2 Calculating the Effective Exchange Rate
3 Significance
4 Notes
5 See Also
6 External Links

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Context

Typically news reports on foreign exchange cite the daily movements of currencies against each other, e.g., the US dollar (USD) against the euro. Yet these reports are likely to give a misleading impression of significant or pervasive actual changes in value are. For example, in the case of the USD:€ exchange rate, one might wish to establish (a) if it is the dollar or the euro that is moving dramatically, or (b) if such movements are likely to have a serious impact on the competitiveness of the products of these respective trading zones.^[1] Both questions can be answered by calculating the different ratios of currencies, with extra weight assigned to the ratios of major trading partners.

If the dollar, for example, declines against the euro only, then its effective depreciation will be far smaller than if it declines against all currencies by the same amount.

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Calculating the Effective Exchange Rate

Using a hypothetical country A as our example, we will consider the effective exchange rate of its currency a against that of trading partners B and C (with currencies b and c respectively). A conducts 67% of its trade with B and 33% of its trade with C. In the first month of the first year, the real exchange rates (RER) were a₁:b₁ and a₁:c₁. Now, the weighted RER is:

RER_W = (a₁:b₁ × 0.67) + (a₁:c₁ × 0.33)

The effective exchange rates are chain-linked indices aggregated from individual exchange rates with the corresponding year's weighted values.^[2] The nominal effective exchange rate in month m of year t (CI_t,m), is given by the following formula:

where is the change in the effective exchange rate from January year t-1 to January year t calculated with the year t-1's weighted value of trade and is the change from January year t to month m of year t with year t's weighted value of trade. The formula for is given by the following geometric mean.

where e_j,t,m is the nominal exchange rate of a in terms of foreign currency j at month m of year t, and w_j,t is the weight of exports to country (or region) j in year t.

Another cautionary note: in the passage above, real exchange rates were presented first, since they're mathematically more intuitive. Because the nominal exchange rate is arbitrary, they vary widely; so that D, for example, which accounts for 1% of A's trade, may have a nominal exchange rate a₁:d₁ of 1,000; it may suffer hyperinflation, so that in year 2, a₁:b₁ = 100. Yet the real exchange rate, unlike the nominal exchange rate, might remain about the same. Instantaneously, the NER has no significance whatever; instantaneously, the RER does. From period 1 to 2, the change in NER has little significance, since a change in NER may reflect hyperinflation, a collapse in the exchange value, or combination of the two.

However, systems of national income and product accounting usually reverse the sequence, and calculate changes in the real effective exchange rate from changes in the nominal effective exchange rate, using price indices from the relevant countries.^[3]

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Significance

The real effective exchange rate (REER) is subject to greater methodological debate than is the nominal effective exchange rate (NEER), since the NEER requires only data on trade volumes and daily FOREX quotes, and the REER requires price indexing. In theory, REER contains information useful to estimating the future growth in exports and imports for a country since it expresses the overall premium that consumers in that country pay relative to consumers in the country's trading partners. If REER is high, then the currency is cheaply valued relative to its domestic purchasing power; exports will be expensive, while imports will be cheap.

In practice, this is rarely a good predictor. In contrast, NEER is more likely to be meaningful in anticipating very localized (e.g., industry- or product-specific) competitive pressures.

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Notes

↑ The US dollar may be regarded as a trading zone since several countries peg their currency to it; the Eurozone includes a growing number of EU member states, including all but two the countries that were members in 1995 (UK and Denmark).
↑ For an explanation of chain-linked indices, please see "Chained vs non-chained calculations" .
↑ "Explanation of the Effective Exchange Rate (Nominal, Real)," Bank of Japan