Real Effective Exchange Rate

Indian Economy glossary

Also called: REER · Topic: Balance of Payments and Exchange Rates · NCERT: Beyond NCERT

Meaning

The Real Effective Exchange Rate (REER) is the NEER (Nominal Effective Exchange Rate: a trade-weighted average of the rupee's exchange rates against a basket of partner currencies) adjusted for the gap between India's inflation and its partners' inflation.

  • Formula (as an index): REER = NEER × (Indian price index ÷ weighted partner price index)
  • It shows India's external competitiveness, meaning how cheap or costly Indian goods are compared with goods from its trading partners.
  • In the RBI's series, a rise in REER means the rupee has appreciated in real terms. A REER above 100 means the rupee is overvalued compared with the base year, so Indian exports lose price competitiveness.

Explanation

From one rate to a basket: why "effective"

  • Bilateral rate: the rupee against one currency, such as ₹/$.
  • The rupee can rise against the dollar and fall against the euro at the same time.

  • So a single bilateral rate can give the wrong picture.

  • NEER fixes this. It takes a trade-weighted average of many bilateral rates.

  • A partner with a bigger share of India's trade gets a bigger weight.

  • But NEER looks only at currency prices. It ignores what is happening to goods prices.

From nominal to real: why inflation matters

  • Buyers compare the actual prices of goods, not just currency prices.
  • If Indian inflation is higher than partners' inflation:
  • Indian goods become dearer abroad, even if the NEER does not change.
  • So the REER rises, which is a real appreciation.

  • Exports lose competitiveness.

  • If the rupee falls in nominal terms only as much as the inflation gap:

  • The REER stays the same.

  • India gains no competitiveness.

  • REER is the "effective" (basket) version of the real exchange rate. For one country pair, the real exchange rate is R = eP*/P (e = rupee price of foreign currency, P* = foreign price level, P = Indian price level).

What makes REER rise or fall

REER rises (real appreciation, bad for exports) REER falls (real depreciation, good for exports)
Rupee strengthens in nominal terms (NEER up) Rupee weakens in nominal terms (NEER down)
Indian inflation is higher than partners' inflation Indian inflation is lower than partners' inflation
Big inflows of capital or remittances push up the rupee or domestic prices (Dutch disease) Partners have higher inflation

Worked example (made-up numbers)

  • NEER index = 95, Indian CPI index = 130, weighted partner CPI index = 110.
  • REER = 95 × (130 / 110) ≈ 112.
  • What this means:
  • In nominal terms, the rupee has fallen, because the NEER is below 100.
  • But Indian prices rose faster than partners' prices.

  • So in real terms, the rupee is overvalued by about 12%.

  • Lesson: a weaker rupee on paper can still mean weaker export competitiveness.

In India

  • Who measures it: the RBI publishes NEER and REER indices. The main index uses a 40-currency basket with base 2015-16 = 100 [1]. A smaller 6-currency index is also published.
  • The 2021 revision (RBI Bulletin, January 2021) [1]:
  • The base year moved from 2004-05 to 2015-16 [1].
  • The basket grew from 36 to 40 currencies. It now covers 88% of India's total trade, up from 84% [1].
  • 8 currencies were added: Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania and Ukraine. Together they had 5.4% of India's merchandise trade [1].

  • 4 currencies were dropped: Argentina, Pakistan, Philippines and Sweden. Together they had only 1.4% of trade [1].

  • How the index is built:

  • Weights: they change over time. Each partner's weight is based on the geometric mean of India's trade (exports plus imports) with it over the preceding three years [1].
  • Price index: the REER is CPI-based [1].
  • Trend: the new REER stayed close to 100 for most of 2004-05 to 2019-20 [1].

  • Methodology notes: RBI Bulletin issues of December 2005, April 2014 and January 2021 [1].

  • Policy use: under today's managed float, the exchange rate is mostly set by the market, but the RBI steps in when needed.

  • The RBI does not target any fixed level of the rupee.
  • It watches the REER and intervenes to smooth excess volatility.

  • During big inflow surges, it builds forex reserves (sterilised intervention). This keeps the REER from rising too far above 100.

  • 1991 lesson:

  • India's rupee was pegged and administered. Indian inflation stayed above partners' inflation for years.
  • So the rupee became overvalued in real terms.
  • This widened the trade deficit and fed the 1991 BoP crisis (balance of payments crisis).
  • The rupee was devalued in July 1991, and market-determined rates followed in 1993.

Don't confuse with

  • NEER: NEER is a trade-weighted average of nominal rates only. REER also adjusts for relative inflation. Only the REER measures competitiveness.
  • Real exchange rate (R = eP*/P): R is bilateral, against one country. Here a rise in R means real depreciation. In the RBI's REER index, a rise means real appreciation. Check which way the index moves before you answer.
  • Nominal depreciation: a fall in ₹/$ is not the same as a gain in competitiveness. If Indian inflation cancels it out, the REER does not fall.
  • PPP (purchasing power parity): PPP is a long-run theory that exchange rates move with relative price levels. REER is a measured index that shows how far the rupee is from its base-year competitiveness.

Prelims Hooks

  • REER = NEER adjusted for relative inflation. It measures external competitiveness.
  • In the RBI series, REER above 100 = overvaluation (exports lose competitiveness). Below 100 = undervaluation.
  • The RBI's 40-currency NEER/REER uses base 2015-16 = 100. In 2021 it replaced the 36-currency, 2004-05 series and now covers 88% of India's trade [1].
  • The RBI's REER uses CPI as the price index. Its weights are time-varying and based on the preceding three years' trade [1].
  • Trap: under a fixed nominal rate, higher Indian inflation causes a real appreciation (REER up), not a depreciation.
  • Trap: a nominal depreciation of the rupee does not always lower the REER. Relative inflation can cancel it out.

Mains Points

  • Weak rupee vs strong rupee debate:
  • The REER, not the ₹/$ rate, decides export competitiveness.
  • A nominal depreciation that only matches the inflation gap gives no real gain.

  • So policy should focus on low inflation and higher productivity, not on pushing the rupee down.

  • Lesson of 1991 and the managed float:

  • Under a peg, persistent inflation gaps cause a silent real appreciation.
  • Exports fall, the trade deficit widens and reserves drain. This happened before the 1991 BoP crisis.

  • The RBI's managed float with REER monitoring is the answer to that lesson.

  • Capital inflows and Dutch disease:

  • Large inflows of capital or remittances can push the REER well above 100.
  • This hurts manufacturing and other tradables (goods that can be sold abroad).
  • Sterilised reserve building by the RBI protects competitiveness, but it has costs. Holding large reserves is expensive, and managing the money supply after intervention is hard.

Related concepts

Read more

Sources

  1. 1RBI Bulletin (January 2021), "Revision of NEER and REER Indices"rbi.org.in · tier 1