But modern economic systems are complicated, and a simple exchange rate, whether floating or indexed, does not often bring out all the intricacies of two currencies. It is for this reason that the real effective exchange rate (REER) is often used by economists and central banks.
What is an RRSP?
The real effective exchange rate is a measure of the comparative health of a country’s currency against the currencies of the countries with which it trades. The RRSP is used to determine whether a country’s currency is undervalued or overvalued or just valued, allowing the country’s central bank to adjust its currency accordingly.
The REER is used as an index to measure the competitiveness of a country’s trade with its trading partners. A high REER indicates that the country is not competitive in trade and that the country has to pay more for the products it exports, while paying less for the products that the country imports.
âOne index of our competitiveness is called the ‘real effective exchange rate’. Think of it as the nominal effective exchange rate adjusted for inflation. The higher it is, the less the exchange rate has depreciated to compensate for inflation, and the less competitive we are, âsaid former RBI Governor Raghuram Rajan.
How is the RRSP calculated?
A currency’s RRSP is calculated by finding the average of bilateral exchange rates between a country and its trading partners, and then adjusting these to account for each partner’s trade share.
For example, if the United States trades only with India, the European Union, and China, and these countries represent 20%, 50%, and 30% of trade with the United States, respectively, then the current exchange rate of the rupee would be multiplied by .20 to weigh it, and adjusted for inflation as well, then compared to the weighted averages of the yuan and the euro to compare the REER of the three currencies.
This would allow economists to determine India’s trade competitiveness with the United States relative to the EU and China.
What should the RRSP be?
The REER can be adjusted by changing the trade weighting, as well as changing the real exchange rate of the underlying currency. By lowering the REER, better commercial competitiveness is ensured. But doing so by depreciating the real exchange rate is not always a good idea.
âAn undervalued exchange rate might have made sense in the past for countries with weak businesses and small domestic markets. India is now in a very different position from the export-dominated East Asian Tigers when they embarked on the growth path. The ideal exchange rate for us is neither strong nor weak, it is fair, âRajan said.
âUsually market forces drive you to this Goldilocks rate. Still, there are circumstances in which rapid capital inflows or outflows can move the rate to a level that is unlikely to be supported by fundamentals. While the RBI does not claim to know precisely the equilibrium level of the exchange rate at any given time, we do step in to moderate the adjustment whenever we believe the move is extreme, sentiment driven, and likely to fall. ‘reverse. Our intention is to avoid overspending and excessive volatility, rather than standing in the way of the necessary adjustment, âhe added.
(Edited by : Shoma bhattacharjee)