Most of us individuals would be interested in knowing the exchange rate of the rupee in relation to the currency of another country. A country however trades with many other countries. So the home currency’s exchange rates with all the trading partners have to be taken in to account to judge the currency’s competitiveness. This is done by assigning weights to all the trading partners, depending on the quantum of trade with that country. The nominal exchange rate of the home currency with each trading partner country is multiplied by the relevant weight. This weighted average exchange rate is the Nominal Effective Exchange Rate. An index of these rates is computed from a base-year – 2004-05.

The real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the two countries. The core equation for real exchange rate is RER= eP*/P1 , where, e is the nominal exchange rate, P is the inflation in home country and P1 is the inflation in the trading partner country. The RER is multiplied by trade weights and an index is composed of the weighted average to form the REER. The RBI is using the CPI to compute the REER from 2014; it was using the WPI earlier.

The RBI releases 6- and 36-currency trade and export weighted NEER and REER. The trade-weighted EERs use weights based on the total trade (imports and exports) while the export-weighted EERs use just exports for assigning weights. 3-year moving average trade and export weights are used.

Also read: Is the rupee really overvalued?

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