Real Effective Exchange Rates

Effective exchange rate

The effective exchange rate measures a currency against a basked of other currencies. This is usually trade-weighted. When looking at the effective Sterling exchange rate we will compare the value of Sterling against our main trading partners – The Euro, the Dollar, the Yen e.t.c and give a weighting depending on how much we trade with that country, e.g. Eurozone 60%. A weighting will be given to different trading countries depending on how significant they are.

The effective exchange rate is good for looking at the overall performance of a currency. For example, the Pound may appreciate against the Dollar – but this  may be due to just temporary weakness in the Dollar. However, if the overall effective exchange rate increases, it suggests the Pound is becoming stronger.

Real exchange rate

The real exchange rate measures the value of currencies, taking into account changes in the price level. The real exchange rate shows what you can actually buy. It is the value consumers will actually pay for a good.

RER = E.R *(price level in country A/Price level in country B)

Increase in real exchange rate

• If a countries real exchange rate is rising it means its goods are becoming more expensive relative to its competitors.
• An increase in the real exchange rate means people in a country can get more foreign goods for an equivalent amount of domestic goods.
• Therefore an increase in the real exchange rate will tend to increase net imports. Foreigners will buy our less expensive exports. It now becomes more attractive to buy imports. This can cause a widening of the current account deficit and lower domestic AD. It will also help reduce inflation.
• Similarly a fall in the real exchange rate should increase net exports as domestic goods are more competitive.

(Readers Question: Does an increase in Real Effective Exchange Rate increase or decreases international competitiveness for the country? An increase in the real effective exchange rate will decrease international competitiveness. It means the country has relatively more expensive exports, leading to a fall in net Ex)

Inflation and the exchange rate

If the UK experienced inflation of 10% and US had inflation of 0%. We would expect the nominal value of the Pound to fall 10%. In this case, the real exchange rate would stay the same. The Pound has fallen 10%, but British goods are 10% cheaper. The amount of goods you can buy stays the same.

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Effective exchange rates

Exchange Rate Indices (ERIs)

Between the Bretton Woods Agreement in 1944 and the currency realignment of the Smithsonian Agreement in 1971, the US dollar provided one benchmark against which changes in the value of other currencies could be measured. This was because up to that time, the value of most currencies remained fairly stable in terms of the dollar, and significant "step" changes to exchange rates were infrequent and confined. Since 1970, however, there have been much larger movements in exchange rates and it can no longer be assumed that changes in rates against the dollar accurately indicate the overall change in the exchange rate for a currency.

To measure the overall change in the exchange value of a currency, a weighted average of the movements in cross-exchange rates against a basket of other currencies can be used, with the weights reflecting the relative importance of the other currencies, as measured by trade flows between the relevant countries.

To reflect changing trade flows, effective exchange rate indices (ERIs) with different currency, weight compositions and methodologies have been introduced. On 1 January 1977, an ERI relating to 1972 trade flows (formerly 1969 trade flows) with a base date of 18 December 1971 (i.e. the date of the Smithsonian Agreement) was inaugurated. This was followed on 2 February 1981 by an index relating to 1977 trade flows in all goods and with a base year of 1975 = 100. This was replaced on 3 January 1989 by an index relating to weights derived from disaggregated trade flows in 143 manufactured products in 1980, and with a base year of 1985 = 100. This was subsequently updated to a base year of 1990 = 100 (see below for further details).

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