In this article we shall discuss the Nominal Effective and Real Effective Exchange Rates, which are fundamental for complex long term analysis and forecasting of an exchange rate as that way we can analyze the Demand and Supply of a Foreign Currency in a country. In Economic Theory prices, including foreign exchange rates, depend on Demand and Supply and everything else like Export/Import, Expectations, Rates, Inflation, Unemployment etc. are factors directly or indirectly influencing the Demand and Supply of foreign currency and consequently the exchange rate. We shall discuss the Demand and Supply of foreign currency in the next article.
The exchange rate of a national currency can change towards different foreign currencies in a different directions and different proportions. For example, USD can appreciate towards EUR, but depreciate towards GBP at the same time frame. For the purpose of understanding the dynamics of a currency we need to use an index of a currency exchange rate or in other words, the Nominal Effective Exchange Rate.
Nominal Effective Exchange Rate is an index of a currency exchange rate which is calculated based on relation of a national currency and a basket of foreign currencies. The basket is weighted based on specific gravity (density) of foreign currencies in the currency transactions of the national economy. Nominal Effective Exchange Rate is calculated in the following way:
– is the Nominal Effective Exchange Rate.
i – is the trade partner country.
– is the index of nominal exchange rate which is equal to nominal exchange rate, in the timeframe under review, divided to the nominal exchange rate in the base timeframe.
– is a specific gravity of a country/trade partner in the total International Trade of a Nation under review. It’s calculated dividing the sum of EX (export) and IM to and from the trade partner to the total EX and IM of the Nation under review in the timeframe under review.
The steps for calculating the Nominal Effective Exchange Rate according to IMF (International Monetary Found) are the following:
1) Choose base year, it should be the year when the country under review had the highest profit in international trade, so EX-IM=max
2) Choose calculation method for calculating the mean, median or mode value of the exchange rate for a year.
3) Identify which countries can be accounted as main trade partners of the National economy under review, based on EX+IM values from highest to lowest.
4) Calculate the specific gravity of a trade partner in the total International Trade of the National economy under review.
5) Calculate the index of the exchange rates of the countries based on the base year exchange rate.
6) Weight the calculated exchange rates based on specific gravity of each trade partner in the IT of the Nation under review.
Nominal Effective Exchange Rate shows the price of the currencies, however not the price levels in the country. In order to understand the real trends we need to take into account the Inflation. We can do that using the Real Effective Exchange Rate. The Real Effective Exchange Rate is calculated in the following way:
– is Real Effective Exchange Rate.
– is the index of real exchange rate which is equal to real exchange rate, in the timeframe under review, divided to the real exchange rate in the base timeframe.
The Real Effective Exchange Rate is an indicator describing the competitiveness of a country in the International Market and must be taken into consideration as a key factor when predicting if a Central Bank of a country will change the Interest Rates or not, or if yes, how will it affect the International Trade of the country and consequently the National Economy, consequently the exchange rate. If the Real Effective Exchange Rate is increasing, then the competitiveness of the country is downcreasing, Export is becoming more expensive and consequently downcreasing and Import is becoming cheaper, consequently increasing and vice versa. Even more, when creating the index taking as a basis the year when the EX-IM=max, we can find the possible target Real Effective Exchange Rate of the Central Bank when intervening and reviewing Interest Rates in the long run.
In the next articles we will show how to calculate the Nominal Effective Exchange Rate and how to calculate the Real Effective Exchange Rate with an example.
Any questions? Please ask in the Forex Traders Forum