The rupee pared down most of its gains against the US dollar recently, after the Federal Reserve’s hawkish stand on interest rates in the future. A weaker rupee often means different things for different industries, depending on whether they are importing items or exporting them. For many consumers, a weaker rupee means more expensive imports of luxury goods and electronics.

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But modern economic systems are complicated and just a simple exchange rate, whether floating or pegged, does not often highlight 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 instead.

What is REER?

The real effective exchange rate is a measure of the comparative health of a nation's currency against the currency of the nations it trades with. REER is used to determine whether a nation's currency is undervalued or overvalued or fairly valued, allowing the nation’s central bank to adjust its currency accordingly.

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REER is used as an index to measure the competitiveness of a country’s trade with its trade partners. A high REER reflects that the country is uncompetitive in trade and the country has to pay more for the products they export, and at the same time are paying less for the products that the country is importing.

“An index of how competitive we are is called the 'real effective exchange rate.' Think of that as the nominal effective exchange rate adjusted for inflation. The higher it is, the less the exchange rate has depreciated to offset inflation, and the more uncompetitive we are,” former RBI governor Raghuram Rajan had said.

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How is REER calculated?

The REER of a currency is calculated by finding out the average of the bilateral exchange rates between one country and its trading partners and then adjusting those to account for the trade share of each partner.

For example, if the US trades with just India, the European Union and China and the countries account for 20 percent, 50 percent and 30 percent of trade with the US, respectively -- then the current exchange rate of the rupee would be multiplied by .20 to weigh it, and adjusted for inflation as well, and 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 the trade competitiveness of India with the US when compared to the EU and China.

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What should the REER be?

The REER can be adjusted by changing the weightage of trade, and also by modifying the real exchange rate of the underlying currency. By bringing the REER lower, better trade competitiveness is ensured. But doing so by depreciating the real exchange rate is not always a good idea.

“An undervalued exchange rate might have made sense in the past for countries that had weak firms and small domestic markets. India is in a very different position today from the export-led East Asian tigers when they embarked on their growth path. The ideal exchange rate for us is neither strong nor weak, it is just right,” Rajan had stated.

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“Typically, market forces get you to this Goldilocks rate. Yet there are circumstances where rapid capital inflows or outflows can move the rate to a level that is unlikely to be supported by fundamentals. While the RBI would not claim to know precisely what the equilibrium level of the exchange rate is at any given point in time, we intervene to moderate adjustment whenever we believe the movement is extreme, driven by sentiment, and likely to be reversed. Our intent is to prevent overshooting and undue volatility, rather than to stand in the way of the needed adjustment,” he added.

(Edited by : Shoma Bhattacharjee)