A Description To Real Effective Exchange Rate (REER)

The trade weighted exchange rate when adjusted for inflation is referred to as the real effective exchange rate in context of external balance approach. The average weight of a currency in relation to a basket of other major currencies when adjusted to balance the effects of inflation is known as real effective exchange rate.

The determination of weights is done by comparison of the relative trade balances, in terms of one country's currency, with each other country within the index. The real effective exchange rates are used with PPP (purchasing power parity) in order to gauge an exchange rate’s over- or undervaluation in relation to a particular and specified norm.

Use of PPP with REER is not an exact science and also both the PPP and REER have same problems. For example, choosing a base year is one of the major problems with PPP and similar is the problem with real effective exchange because of the same reasons. Use of some anonymous base year for beginning the analysis may sometimes distort the results.

On the other hand, it is logical to start analysis of both purchasing power parity and the real effective exchange rate in the 1971–1973 periods, during which the exchange rate system of Bretton Woods broke up, yet this was a highly inflationary and therefore distorting period as far as such analyses are concerned.

The mechanism of transmission is the external balance. In the jargon of economists; the external imbalance or enlarging deficit of current account is caused because of the overvaluation of an important real effective exchange rate relative to a specified norm of 100. a logical depreciation of real effective exchange rate is essential in order to maintain the balance or the equilibrium.

To restore the equilibrium there is another way by the trade-weighted exchange rate depreciation or by the depreciation in the nominal exchange rate or also by a sharp fall of inflation. However, significant REER overvaluations can stay for considerable time periods.

In few cases several years are taken before any adjustment process to take place for eliminating the overvaluation. A considerable example again is that of the Russian rouble, where the real effective exchange rate value was overvalued by more than 50% for around two and a half years depending on the use of base year—before it finally succumbed to gravity.

The real effective exchange rate value of the Mexican peso and the Bolivar of Venezuela indicates a considerable overvaluation for several years and in the case of the Mexican peso to a larger extent than before the crises in the year 1994–1995. The significance of real effective exchange rate is that it is a useful tool for over- or undervaluation analysis and diagnose and a consequent need for an adjustment to restore equilibrium—but it cannot predict when that will happen.