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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: 

NEER (Nominal Effective Exchange Rate) REER (Real Effective Exchange Rate)
Represents the value of a currency relative to a basket of multiple foreign currencies. Takes into account inflation differentials between a country and its trading partners.
Does not consider inflation adjustments. Adjusts the NEER for inflation to provide a more accurate measure of competitiveness.
Provides a measure of a currency’s strength or weakness in the foreign exchange market. Reflects a currency’s real value in terms of purchasing power, accounting for relative price levels.
Helps assess a country’s international competitiveness based on exchange rate movements. Offers insights into competitiveness by considering both nominal exchange rates and price levels.
Calculated as a weighted average of exchange rates between the domestic currency and foreign currencies. Calculated by dividing NEER by the ratio of domestic and foreign Consumer Price Index (CPI).
Typically used to evaluate currency performance and competitiveness in the global market. Used to assess a country’s competitiveness in terms of both exchange rates and relative price levels.

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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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NEER & REER FAQs

What is the reer of currency?

REER of a currency is the adjusted measure that considers inflation differentials, reflecting its competitiveness in terms of purchasing power.

What is the impact of NEER and Reer in UPSC?

The impact of NEER and REER in UPSC is their relevance to the economics and international relations syllabus, often appearing in questions to assess candidates' understanding of exchange rate dynamics and trade competitiveness.

What is NEER in economics?

NEER in economics refers to the Nominal Effective Exchange Rate, which measures a currency's value against a basket of foreign currencies.

Why is reer better than NEER for forecasting future exchange rate?

REER is considered better than NEER for forecasting future exchange rates due to its adjustment for inflation differentials, providing a more accurate reflection of purchasing power and competitiveness.

What is NEER and reer rates?

NEER and REER rates refer to the values or levels of the Nominal Effective Exchange Rate and Real Effective Exchange Rate, respectively.

Who calculates NEER and reer?

NEER and REER are typically calculated by central banks, financial institutions, or international organizations such as the International Monetary Fund (IMF).

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