The effective exchange rate is an index that describes the strength of a currency relative to a basket of other currencies. Suppose a country has
trading partners and denote
and
as the trade and exchange rate with country
respectively. Then the effective exchange rate is calculated as:
Although typically that basket is trade-weighted, the
trade-weighted effective exchange rate index
The trade-weighted effective exchange rate index, a common form of the effective exchange rate index, is a multilateral exchange rate index. It is compiled as a weighted average of exchange rates of ''home'' versus ''foreign'' currencies, with th ...
is not the only way to derive a meaningful effective exchange rate index. Ho (2012) proposed a new approach to compiling effective exchange rate indices. It defines the effective exchange rate as the ratio of the "normalized Exchange Value of Currency i against the US dollar" to the
normalized exchange value of the "benchmark currency basket" against the US dollar. The US dollar is here used as
numeraire for convenience, and since it cancels out, in principle any other currency can be used instead without affecting the results. The benchmark currency basket is a GDP-weighted basket of the major fully convertible currencies of the world.
Bilateral exchange rate involves a
currency pair
A currency pair is the dyadic quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency, quote currency, or ...
, while an
effective exchange rate
The effective exchange rate is an index that describes the strength of a currency relative to a basket of other currencies. Suppose a country has N trading partners and denote Trade_i and E_i as the trade and exchange rate with country i respe ...
is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by the appropriate foreign price level and deflates by the home country price level. There are four aspects for alternative measures of REER which are (a) using end-of-period or period averages of the nominal exchange rate. (b) choosing price indexes. (c) in obtaining the real effective exchange rates, deciding upon the number of trading partners in calculating the weights. (d) deciding upon the formula to use in aggregation. Considering all these aspects together led to the calculation of a great number of alternative series.
The
Bank for International Settlements
The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks".
The BIS carries out its work thr ...
provides four sets of effective exchange rates, updated monthly. One pair uses a "narrow" set of 27 countries with data going back to 1964, both in nominal terms and as a "real" effective exchange rate adjusted using consumer price inflation. The "broad" set covers 61 economies, but with data only from 1994, again available both as a nominal series and adjusted for relative inflation. The trade weights are not updated monthly; as of March 2016, the base period was the average over 2011–13.
Effective exchange rates are useful for gauging whether a currency has appreciated overall relative to trading partners. For example, in 2015 the Chinese RMB depreciated about 8% against the US dollar. However, more of China's trade is with Asia and Europe than with the United States, and the dollar appreciated against those currencies. The net effect was that once weighted by trade shares the value of the Chinese currency actually appreciated approximately 10% relative to its trading partners.
EER are still volatile over short periods of time and a poor guide for comparing standards of living across countries. For that purpose
Purchasing Power Parity
Purchasing power parity (PPP) is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currency, currencies. PPP is effectively the ratio of the price of ...
measures are more appropriate.
See also
*
Foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspec ...
*
Purchasing Power Parity
Purchasing power parity (PPP) is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currency, currencies. PPP is effectively the ratio of the price of ...
References
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External links
BIS Effective Exchange Rate Home PageFRED2 Database BIS Data as graphsLok Sang Ho, "Globalization Exports,and Effective Exchange Rate Indices," Journal of International Money and Finance, Volume 31, Issue 5, September 2012, Pages 996–1007Global Nominal and Real Effective Exchange Rates Online
Foreign exchange market