NEER & REER Concept, Definition, Differences, Examples

NEER & REER

The concepts of NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) are fundamental tools used in analyzing a country’s exchange rate dynamics. These indicators assist policymakers and economists in understanding a country’s exchange rate movements and evaluating its international trade competitiveness.

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Nominal Effective Exchange Rate (NEER)

The Nominal Effective Exchange Rate (NEER) is a weighted average exchange rate that represents the value of a country’s currency relative to a basket of multiple foreign currencies. It is calculated by taking the unadjusted weighted average of the exchange rates between the domestic currency and various foreign currencies.

The NEER is an important indicator used to assess a country’s international competitiveness in the foreign exchange market and can be adjusted to account for inflation differentials through the calculation of the Real Effective Exchange Rate (REER). The NEER provides a comprehensive view of a country’s currency value against multiple currencies simultaneously, allowing for a broader assessment of its exchange rate dynamics.

The formula to calculate the Nominal Effective Exchange Rate (NEER) is as follows:

NEER = (w1 * ER1) + (w2 * ER2) + … + (wn * ERn)

where:

• NEER is the Nominal Effective Exchange Rate.
• w1, w2, …, wn represent the weights assigned to each foreign currency in the basket.
• ER1, ER2, …, ERn are the exchange rates of the domestic currency with each foreign currency in the basket.

The weights assigned to each currency in the basket are typically based on trade flows or other economic factors that reflect the importance of each currency in the country’s international trade. The exchange rates used in the calculation are usually the market exchange rates or official exchange rates, depending on the context and availability of data.

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Real Effective Exchange Rate (REER)

The Real Effective Exchange Rate (REER) is a measure that takes into account the inflation differentials between a country and its trading partners when assessing the value of its currency. It provides a more accurate measure of a country’s international competitiveness by adjusting the Nominal Effective Exchange Rate (NEER) for inflation.

The formula to calculate the Real Effective Exchange Rate (REER) is as follows:

REER = (NEER * CPI Domestic) / (CPI Foreign)

where:

• REER is the Real Effective Exchange Rate.
• NEER is the Nominal Effective Exchange Rate.
• CPI Domestic is the Consumer Price Index of the domestic country.
• CPI Foreign is the Consumer Price Index of the foreign country or countries in the currency basket.

The REER takes the NEER and divides it by the ratio of domestic and foreign price levels, as measured by the Consumer Price Index (CPI). This adjustment accounts for differences in inflation rates between the domestic country and its trading partners, allowing for a more accurate assessment of the currency’s real value in terms of purchasing power.

By incorporating inflation differentials, the REER provides insights into a country’s competitiveness in international trade, as it reflects not only nominal exchange rate movements but also relative price levels between the domestic and foreign economies.

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Difference Between NEER and REER

Key differences between NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) can be understood from the following table: 

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NEER and REER Examples

Assume that Country A’s currency is the “A-coin,” and it trades with two major trading partners, Country X and Country Y. The exchange rates and inflation rates are as follows:

Exchange Rates:

• A-coin to X-currency: 1 A-coin = 5 X-currency
• A-coin to Y-currency: 1 A-coin = 10 Y-currency

Inflation Rates:

• Country A’s inflation rate: 3%
• Country X’s inflation rate: 2%
• Country Y’s inflation rate: 4%

NEER Calculation: 

To calculate NEER, we assign weights to each currency based on trade importance. Let’s assume Country X has a weight of 60% and Country Y has a weight of 40% in the currency basket.

NEER = (0.6 * 5) + (0.4 * 10) = 3 + 4 = 7

The NEER for Country A is 7, indicating the average value of the A-coin against the currency basket.

REER Calculation: 

To calculate REER, we adjust NEER for inflation differentials. Using the inflation rates mentioned earlier:

REER = (NEER * CPI Domestic) / (CPI Foreign)

REER = (7 * (1 + 0.03)) / ((5 * (1 + 0.02)) + (10 * (1 + 0.04)))

REER = (7 * 1.03) / ((5 * 1.02) + (10 * 1.04))

REER ≈ 7.21 / (5.1 + 10.4) ≈ 7.21 / 15.5 ≈ 0.4658

The REER for Country A is approximately 0.4658, reflecting the adjusted value of the A-coin considering inflation differentials between Country A and its trading partners.

In this example, NEER provides an average value of the A-coin against the currency basket, while REER adjusts the NEER by considering the inflation rates of Country A, Country X, and Country Y. REER offers a more accurate measure of the A-coin’s competitiveness in terms of purchasing power by accounting for inflation differentials.

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NEER & REER UPSC 

Understanding the concepts of NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) is crucial for the UPSC (Union Public Service Commission) examination. These topics are part of the UPSC Syllabus in the economics and international relations sections. Aspirants preparing for the UPSC exam can take help from UPSC Online Coaching platforms and attempt UPSC Mock Test to have good command over such topics.

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