Learning FX

What is an Effective Exchange Rate?

Effective Exchange Rate on Computer

An effective exchange rate is a figure which is used to compare the value of a currency in relation to a selection of other currencies. Usually, the currency of one country is compared against those of its major trading partners in order to determine its relative level of performance against them. This gives a reliable overall figure for the value of that particular currency at a point in time.  

Effective exchange rates provide one number which can quickly be used to see how the value of a currency compares to many other currencies

Effective exchange rates are calculated by weighing the trade value that a country has with each of the trading partners used in the calculation. The more the country trades with a particular partner, the more their currency will affect the effective exchange rate score. The exchange rates that the currency in question has with the currencies of the country’s trading partners (after they are weighted) are used to calculate the effective exchange rate. The figure produced provides an indication of the strength (value) of that currency.

Usually, effective exchange rates are expressed as an index form relative to a reference period. For example, the pound sterling may have an effective exchange rate of 80 points in September 2021. This will be expressed as Sept 2021 = 80

If a currency’s effective exchange rate increases, this indicates that the strength of that currency is increasing. If the effective exchange rate decreases, this indicates that the strength of that currency is decreasing. Obviously, this will have an effect on the country in question’s economy.

A lowering of an effective exchange rate score will increase a country’s trade competitive as their exports become cheaper to international buyers. On the other hand, an increase in the effective exchange rate means that the country will become less competitive internationally in its ability to export, but will be able to import for less.

How is an Effective Exchange Rate Different From Spot Exchange Rate?

Spot exchange rates are the kind of exchange rate that most people are familiar with. Spot exchange rates are bilateral (between two currencies) exchange rates for an immediate exchange of currency. They just express the value of one currency against another one at a particular moment.

For example, the spot exchange for euros to pound sterling may be 1.18 EUR/GBP at a point in time. This means that 1.18 EUR is worth 1 GBP.

Why Do We Have Effective Exchange Rates?

Effective exchange rates became widely used after the collapse of the gold standard in the early 1970s. Prior to then, many of the major currencies of the world operated according to the gold exchange standard system which was put in place at the Bretton Woods Conference in 1944.

Under this agreement, the value of the dollar was set at a fixed rate against the value of gold. One ounce of gold was set at a value of $35 and other currencies fixed the value of their own currencies against the dollar. The resulting system was one of the fixed exchange rates. Exchange rates did not vary and the relative strength of a currency could be seen by comparing its value to that of the dollar.

After the gold standard system collapsed, comparing the value of a currency against the US dollar in order to determine its value in a broader sense became an unreliable system because the value of the dollar began fluctuating.

To take an example, a country may trade with the dollar for a significant proportion of its trade and the value of its currency may change in one direction against the dollar at a particular moment. If the currency was just compared to the dollar, this would indicate that it has either strengthened or weakened overall. However, at the same moment, its value may change in the other direction against all the other currencies with which it trades. This makes things different.

By looking at the currency’s relationship with all the countries with which it trades in an effective exchange rate calculation it may be that the opposite result is true to what is derived by just looking at its value against the dollar.    

How are Effective Exchange Rates Calculated?

Before looking at how effective exchange rates are calculated, it is helpful to understand the difference between nominal rates and real rates.

Nominal EER and Real EER

Effective exchange rates come as nominal effect exchange rates (NEERs) and as real effective exchange rates (REERs). Real effective exchange rates build on nominal effective exchange rates by adjusting them to compensate for the interest rate of the home country relative to the interest rate of its trading partners.

First, a calculation can be made to discover the NEER and if it is necessary to adjust it according to interest rate differences, this can be done to find the REER.

How are Calculations Made?

In a very simple form, nominal effective exchange rates are calculated by

  1. Weighing a country’s trading partner’s exchange rates to reflect the share they have of the country’s foreign trade.
  2. Multiplying all of the weighted exchange rates
  3. Multiplying that total by 100

While this offers a basic explanation of an effective exchange rate calculation, setting the parameters regarding trading partners and exchange rates is complicated.

How are the Parameters Set?

There is no international standard by which effective exchange rates are calculated. While organisations like the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) have developed methodologies, there is no consensus about how it should be done. As such, different organisations produce slightly different calculations and operate according to different systems.

Deciding what to include in an effective exchange rate calculation can be complicated. Firstly, when considering the trading partners with which a country will be compared, it is necessary to choose some kind of economic framework to decide what trade data to use. When deciding which trading partners to use in a calculation and the weighting of each partner, it is important to use the right data and that that data is robust enough. The data needs to be extensive and issues like gaps in data or inconsistency in measurement can cause issues.

On top of this, there are different approaches towards deciding a country’s main trading partners and in allocating a weighting to each of them. Other things to consider include whether to use end-of-period nominal exchange rates or period average exchange rates or whether to include a wide or narrow range of currencies in a calculation.

Bank of England Rates for Pound Sterling

The Bank of England sites the selection of the number of currencies in its calculation of an effective exchange rate for the pound sterling as a major consideration. Crucially, it states that there is a balance to be struck when choosing the number of currencies to include. They claim that while having more currencies makes the score more representative, it increases the risk that currencies with high-inflation economies will disrupt the score.

As the effective exchange rate is used as a short-term proxy measure for competitiveness, allowing the inflationary depreciation of one currency to have an effect is seen as undesirable. To give both representative and accurate scores, the bank produces two effective exchange rate scores (which it actually calls exchange rate indices, rather than effective exchange rates).

One provides a score for a fewer number of contributory currencies and is known as the principal index. Only economies with a minimum share of 1.0 % of UK imports or exports over the last three years are used in this calculation. The other score, known as the broad index, includes economies with a minimum threshold of 0.5 %.

What is Effective Exchange Rates Used For?

The main use of an effective exchange rate is in assessing the competitiveness of a nation in relation to its trading partners.

The ways in which this figurative assessment of a currency’s value can be used are many. Being able to assess the value of a nation’s currency can help in economic studies, in governmental policy analysis, by forex traders who engage in currency arbitrage or in various other ways.

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