RER vs REER: Real Exchange Rate V.s Real Effective Exchange Rate are might be confusing.
The real exchange rate is the current price paid by businesses and consumers to purchase foreign goods in their home currency. When Americans trade bucks for pounds, the quantity they get hold of is primarily based totally on the actual trade fee. Furthermore, the Real Effective Exchange Rate (REER) is a weighted average of a country’s currency against an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency with the trade balance of each country in the index. An increase in REER for a country indicates that the country’s exports are getting more expensive and imports are getting cheaper loss of competitiveness in trade policy.
In this article, we clarify the differences between RER vs REER (Real Exchange Rate Vs Real Effective Exchange Rate) What is RER vs REER, and how to calculate both rates?
What is the RER vs REER?
RER Meaning: The real exchange rate between two currencies is the product of the nominal exchange rate (such as the dollar price of 1 euro) and the price ratio of the two countries. For example, if the current exchange rate between the US and the UK is $138 per pound, a US consumer would need $1.38 to buy 1 pound of goods.
REER Meaning: The Real Effective Exchange Rate is a measure of a country’s currency’s external competitiveness. This is a weighted average of a country’s currency against a basket of other major currencies (after accounting for inflation differentials). REER is expressed as an index relative to the base year.
How to Calculate the Real Exchange Rate and Real Effective Exchange Rates (RER vs REER)
Calculate the Real Exchange Rate
The Real Exchange Rate (RER) is the value of one currency in terms of another. The RER is calculated by dividing the value of one country’s currency by the other country’s currency.
To calculate the real exchange rate, you will need to know how much one unit of your home country’s currency is worth in terms of your destination country’s currency. You will also need to know how many units of your destination country’s currency are required to buy one unit of your home country’s currency.
There are two formulas that are used to calculate the real exchange rate:
- Value of home country’s money in terms of foreign country’s money
- Value of foreign country’s money in terms
Calculate the Real Effective Exchange Rate Formula
A country’s currency can be considered undervalued, overvalued, or in balance with the currencies of other countries with which it trades. Equilibrium means that demand and supply are in balance and prices are stable.
A country’s REER measures how well this balance is maintained. REER is determined by taking the average bilateral exchange rate between a country. And its trading partners and weighting it to account for each partner’s trade distribution.
The Bank for International Settlements website provides valid exchange rate indices that are updated daily and monthly.
The formula for REER is:
REER Formula breakdown:
- Exchange rates are weighted and averaged. For example, if the currency weight is 60%, the exchange rate is raised to the power of 0.60.
- Similarly for each exchange rate and each weight.
- Multiply by all exchange rates.
Then multiply the final result by 100 to create a scale or index. Some calculations use bilateral trade rates, even as others use actual trade rates. Also, the latter adjusts the trade fee for inflation. An average indicates whether a currency is overvalued relative to one counterparty.
What is the difference between real exchange rate and real effective exchange rate?
The Difference Between the Real Exchange Rate and Real Effective Exchange Rates (RER vs REER)
The real exchange rate and the real effective exchange rate differ greatly. Also, the real exchange rate is based on the theoretical exchange rate of the currency. While the real effective exchange rate is based on what people actually pay to convert their currency.
Because the real exchange rate is based on the theoretical exchange rate. It does not take into account any costs associated with converting the currency. On the other hand, the real effective exchange rate takes into consideration the cost of converting the money. Therefore, the real effective exchange ratio is higher than the real exchange ratio.