Real Effective Exchange Rate – Research Paper Example
REAL EFFECTIVE EXCHANGE RATE and Real Effective Exchange Rate Introduction The real effective exchange rate for most countries result in the nominal index adjusted for the purposes of relative changes in consumer prices. This is because, in such states, it is based on the trade of the country in terms of the primary products and manufactured goods. This means that an increment in the real effective exchange rate signifies the rise of the local currency. This paper analyses the meaning of real effective exchange rate, how it is used, who uses it and its advantages and disadvantages compared to the nominal effective exchange rate.
Real Effective Exchange Rate
World Development Indicators (2005, p. 297), describe the real effective exchange rate as a fraction of the nominal effective exchange rate and the index costs or price deflator. It further defines the nominal effective exchange rate as a criterion of the value of a given country’s currency against a weighted mean of respective international currencies. This means that it appropriates the international competitiveness of a country’s currency that cannot be measured fully using the bilateral trade exchange rates. The nominal exchange rate (NEER) combines all the transactions that involve the exchange rates as a result of import weights of the merchandising patterns. The NEER may initially depict less variation in terms of the exchange rate regarding the currency of the bilateral trade partners. Comparatively speaking, the nominal effective exchange rate of a nation is a refinement of its real effective exchange rate. This means that the real effective exchange rate is much better when comparing bilateral trade than the nominal effective exchange rate. However, according to Hernández and Montiel (2001, p. 20), the real effective exchange rate is affected by the behavior of the nominal effective exchange rate
Advantages and Disadvantages
There are advantages of the real effective exchange rate compared to the nominal exchange rate. Similarly, there are disadvantages of real effective exchange rates compared to the nominal exchange rate. According to Relations Dept. (2007, p. 47), the real effective exchange rate is beneficial in ascertaining whether the currency of a given country is overvalued or undervalued and the actual amount. Another advantage is that it shows the correlation between the purchasing power and the currency of a nation in the international trade. This is as a result of the fact that when the purchasing power parity is relative or absolute, the real effective exchange rate does not change significantly over a span of time. This occurs when there is an equilibrium state in the currencies in the bilateral trade. However, disparity in the real effective exchange rate may not necessarily imply rudimentary misalignment. This is true when tariffs, trade policies, consumption patterns or transportation costs change faster compared to the market construct. In addition, it can be used to measure the competitiveness of international trade. This is as a result of the observed movements that occur in the real effective exchange rate. The movements greatly assist in determining the right intervention of the monetary policy action to be taken by the central bank. Another advantage of the real effective exchange rate is that it gives a much clearer view of the terms of trade than the special drawing right. It is easy to undertake a comparison of a country’s changes that accrue as a result of the real economic prevailing conditions. One of the disadvantages of the real effective exchange rate is that it cannot correct issues that go beyond policymakers such as fixed exchange rates.
Both the nominal effective exchange rate and the real effective exchange rate are used by the central bank of a given nation to measure the performance of the local currency in international trade. One of the differences between the two is that the changes that occur in the nominal exchange rate of the currency within a given period of time take place due to the alterations that occur in the currency value. Such changes also arise due to the related prices of the respective products and services that the currency is intended to buy. Additionally, the weightings of the nominal exchange rate determine the level of trade between the bilateral trading nations. In this regard, it can be used to compare the terms of trade alterations that occur in all the countries that are involved in the international trade. This implies, therefore, that if the nominal effective exchange rate of a country begins to fall, it means that the international trade between the trading nations is deteriorating (Relations Dept. 2007, p. 47). The implication is that a country spends much more on buying services and products from allied trade members during importation.
A nation, through the central bank ought to monitor and preclude any anticipated fall in the real effective exchange rate since such an occurrence leads to a decline of international trade. The implication of this in the international frontier is that the performance of a country’s local currency is weakening. In the end, the international competitiveness of a country’s currency drops significantly.
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Hernández, L., & Montiel, P 2001, Post-crisis exchange rate policy in five Asian countries: filling in the "hollow middle"? [Washington, D.C.], International Monetary Fund, IMF Institute.
Relations Dept., I. M. F. E. 2007, Finance & Development, September 2007. Washington, International Monetary Fund. Viewed 29 June 2015, http://public.eblib.com/choice/publicfullrecord.aspx?p=1608598.Top of Form
World development indicators 2005, Washington, D.C., World Bank. Viewed 29 June 2015, http://site.ebrary.com/id/10078518. Top of FormTop of Form
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