Effective exchange rate

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Effective Exchange Rate is an index that describes the relative strength of a currency relative to a basket of other currencies.[citation needed] Suppose a country has  N trading partners and denote  Trade_i and  E_i as the trade and exchange rate with country i respectively. Then the effective exchange rate is calculated as:

 E_{effective} = E_1 \frac{Trade_1}{Trade} + ... + E_N \frac{Trade_N}{Trade}

Although typically that basket is trade-weighted, the trade-weighted effective exchange rate index 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 a ratio if 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, while an effective exchange rate 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 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 alterative series. [1]

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  1. ^ Erlat, Guzin and Arslaner, Ferhat. "Measuring Annual Real Exchange Rate Series for Turkey". Yapi Kredi Economic Review, Volume 2, Issue 8, December 1997, pp. 35-61.