REAL EFFECTIVE EXCHANGE RATE

BE/RBI NOTE/33/2018

It is essential to know the Exchange rate of Rupee with other currencies.  How to get it?  Here is how we get it.

1. A country trades with other countries. The home currency’s exchange rate with all the trading partners is required to be taken into account in order to judge the currency’s competitiveness.
2. Gauged through the trade made with other partner countries a weight is assigned to all the trading partners.
3. The nominal exchange rate of the home currency with each trading partner is multiplied by relevant weight that is assigned.
4. This weighted average rate is the Nominal Effective Exchange Rate.
5. An Index of rate is computed from a base year 2004-05
6. The Real Exchange Rate is the product of Nominal Exchange Rate and the ratio of prices between the two countries.
7. The core equation for Real Exchange Rate is RER=eP*/P1 where ‘e’ is the Nominal Exchange Rate, P is the inflation in home country and P1 is the inflation in the trading partner country.
8. RER is multiplied by Trade weights and the index is composed of the weighted average to form the REER.
9. RBI has been using CPI to compute REER since 2014 and earlier it was using WPI to compute REER.
10. RBI releases 6 and 36 currency trade and export weighted NEER and REER. The trade weighted EERs use weights based on total trade ie., Exports and Imports and Export weighted EERs use only Exports for assigning weights.
11. Three years moving average trade and exports weights are used.