Exchange Rate Theories: Exchange Rate Pass Troughs
18.1: Exchange Rate
Indices: NEER and REER
As country’s currency can be compared
with any other currency and a given country’s currency can be expected to appreciate compared some currencies
while expected to depreciate against some other currency.
But can we generalize, whether a given country currency is expected to appreciate or depreciate? This can be done
so by comparing the currency value of any country with the currency value of
its major trading partners. Since countries trade with many other countries, to
determine the relative purchasing power of a given currency, it needs to be
evaluated against all other currency values so that the currency’s true value
can be identified. In other words, whether a currency is “over valued” or “under
valued” compared to its major trading partners needs to be determined. This is
done by calculating exchange rate
indices.
These indices are calculated by trade
weighing bilateral exchange rates between the currency and its trading
partners. Two types of Exchange rate indices are calculated
NEER
(Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate).
Let us understand more on how these two
indices are calculated. However more than the methodology, the interpretation
of NEER and REER values is crucial to understand the direction of future
exchange rate movement.
18.2: Methodology to Calculate NEER and REER:
NEER is calculated by tracking the
movements in the nominal exchange rate between a home country and trading
partners adjusted for by the respective weights of the trading partners ( total
i umbers). A NEER is the exchange rate of the domestic currency vis-à-vis other
currencies weighted by their share in either the country’s international trade
or payments For example, suppose India only exports to and imports from four
other countries in the world. Then i range from 1-4.
NEER is calculated as
4
NEER
= ∑Wi / Ei ............. ( Eq.18.1)
i= 1
Where Ei is the period average nominal exchange rate
between the home country and each trading partner in period. Wi is the appropriate total trade weight for
each trading partner.
REER is calculated by multiplying NEER
with the effective relative price indices of trading partners. The relative
price indices are calculated by the weighted wholesale price index of trading
partners and the consumer price index for the home country).
4
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Ptrading
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REER = ∑ NEERi *
|
partners
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.................. ( Eq.18.2)
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Phom e
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i= 1
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country
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More details about NEER and REER calculation “Macro
Economics” or readers can
can be found from any text book on
visit the following website:
The following table, Table 18.1 indicates the
NEER and REER calculated by Reserve Bank of India.
Table 18.1:
REER and NEER for Indian Rupee http://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=861
INDICES OF REAL EFFECTIVE EXCHANGE RATE (REER) AND NOMINALEFFECTIVE
EXCHANGE RATE
(NEER) OF THE INDIAN RUPEE
Table 18.1 REER and NEER for Indian Rupee ( Cont..):
INDICES OF REAL EFFECTIVE EXCHANGE RATE
(REER) AND NOMINALEFFECTIVE
EXCHANGE RATE (NEER) OF THE INDIAN RUPEE
P : Provisional.
Note : For detailed methodology of compilation of indices, see "Revision of Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) Indices", Reserve Bank of India Bulletin, December 2005.
The REER index indicates that, if the relative inflation in one country ( in comparison to inflation level in other countries ), then REER is 100 and the exchange rate is governed by the comparative inflation rate. If the REER is > 100, then the INR is “overvalued” and is expected to depreciate. If REER < 100, the INR is “undervalued” and is expected to appreciate in future. The degree of undervaluation is higher when REER is value if 66.36 as compared to when it is 67.48.
If the REER is >
100, then the INR is “overvalued” and is expected to depreciate. If REER <
100, the INR is “undervalued” and is expected to appreciate in future.
Depending on the
changing profile of export-import partners, countries may periodically revise the
trading partner’s currency list. It is interesting to note here that RBI was
calculating NEER and REER with respect to 36 currencies. In other words, RBI
was considering India’s trading partners to be 36. In the Equation 18.1 and
18.2, the i ranges from 1 to 36. However, in 2005, RBI reduced the trading
partner’s currency to six(6).
Box 8.3: RBI to revise NEER/REER Indices
RBI Press Release, November 4, 2005.
The Reserve Bank of India is revising the Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate
(REER) with new six-currency indices.
It is also revising its thirty six-country indices. As against the present
practice of having three base years in the case of existing five-country
indices, viz., 1991-92, 1993-94 and 2003-04, the last being a moving base
updated every year to facilitate comparison with a more recent period, the new
six-currency indices will have 1993-94 as fixed base and 2003-04 as a moving
base, which would change every year as at present.
The new six-currency indices will
include U.S.A, Eurozone, U.K., Japan,
China and Hong Kong SAR. The new
indices will also have two new currencies - both Asian - the Chinese Renminbi and the Hong Kong Dollar. Two currencies in the
existing five country series, viz., French
Franc and Deutsche Mark have
been replaced by Euro in the new
indices.
REER values (for 2008-09 April, May and
June) given in Table 18.1 ( based on 6 currency index) indicate these values to
be 112.16, 107.48 and 108.25. Hence it can be concluded that Indian rupee is
expected to depreciate against its major trading partners in future. This
information can be used by Indian companies to get a directional view on the
exchange rate.
18.3: Exchange
Rate Pass – through:
Exchange
rate pass through measure the percentage change in domestic prices of goods
resulting from one percentage change in the exchange rate. If 1 percentage change in exchange rate results in 1 percentage change in domestic
goods prices, then pass through is 100% or a complete pass through. Less than
one-to-one change in domestic price compared to exchange rate is an incomplete or partial pass through.
For example, if the domestic currency
depreciates against foreign currency, the imported goods become costlier. Hence
consumers start replacing the imported goods with domestic goods, thus leading
to an increase in prices of domestic goods. Depreciation of home currency also
affects the cost of production of domestic goods, if the domestic good has some
imported component, thus increasing the domestic goods price.
Change in exchange rate’s impact on
intermediate goods price is known as “first
stage” pass through. The impact on domestic goods is known as “second stage” pass through.
A complete exchange rate pass through
indicates that PPP holds i.e, that the prices of tradable goods when expressed
in the same currency are same across countries,
It is pertinent to note here that
change in exchange rate does not affect only the import goods and domestic
goods prices, it also affects the export prices. Change in exchange rate
affects 4 economic factors in a country i.e,
import and export prices, consumer prices,
investments and trade volumes. Of these four factors, exchange rate pass-through
measures the effects of exchange rate changes on import and export prices.
Many empirical studies have focused on
understating the degree of these pass through and came to the conclusion that
complete pass through never occurs, though incomplete pass though occurs with
varying degree – thus refuting the purchasing parity hypothesis. In other
words, price level alone between countries has limited impact on future
exchange rate. Hence companies trying forecast exchange rate should look beyond
the price level parity conditions. Other parity condition i.e, interest rate parity and its impact on
exchange rate is discussed in later sessions.
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