EFFECTIVE EXCHANGE RATE OR EER (Syllabus GS Paper 3 – Economy)

Context: Recently, the rupee has depreciated by 27.6% against the US dollar since April-end 2014, during the ruling government's tenure. However, over the last decade, the Indian currency has shown a stronger position in 'real' terms against major global currencies despite its fall against the dollar.

Effective Exchange Rate or EER

• About: The EER stands for Effective Exchange Rate and signifies the weighted average of the rupee’s exchange rates against the currencies of India’s major trading partners.

o The EER is measured by an index similar to the consumer price index (CPI).

• Determining Currency Weights: In the EER are determined by the respective shares of individual countries in India’s total foreign trade.
• Comparison: Similar to the CPI, where commodity weights are based on their relative importance in the consumption basket, the EER's currency weights are based on trading partner importance to India.

• There are two measures of EER

o Nominal EER or NEER: It represents an unadjusted weighted average rate of one country's currency against a basket of various foreign currencies.

Calculation of NEER Indices: The Reserve Bank of India has constructed NEER indices of the rupee against a basket of six and 40 currencies.

Composition of NEER Indices: The former index includes a trade-weighted average rate with a basket comprising major currencies like US dollar, the euro, the Chinese yuan, the British pound, the Japanese yen and the Hong Kong dollar.

Base Year: 2015-2016

o Real EER or REER: It is the real effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.

External Value Evaluation: The NEER tracks changes in the rupee's value against a basket of global currencies, offering a comprehensive view of its international standing.

Limitation: NEER neglects inflation, failing to account for shifts in the rupee's internal value over time.

Base year: 2015-2016