What are NEER and REER?

NEER is the Nominal Effective Exchange Rate, and REER is the Real Effective Exchange
Rate. Unlike nominal and real exchange rates, NEER and REER are not determined for
each foreign currency separately. Rather, each is a single number (usually expressed as an
index) that expresses what is happening to the value of the domestic currency against a
whole basket of currencies. These other currencies are picked on the basis of that country's
trade with the domestic economy. India trades with a large number of countries such as the
US, EU, Japan and Middle East. With each individual currency, the rupee has a different
nominal exchange value. To calculate NEER we weight the nominal exchange rate of the
rupee against the currencies of these trading partners by their share in India's trade. Then,
by summing the weighted exchange rates, we get the NEER. By setting the NEER for some
year at 100, we can track changes in the rupee's value as percentage changes over the
base year.
How is REER calculated?
Similar to the NEER, the REER is the weighted average of real exchange rates, weighted by
the relative importance of each country in trade with the domestic economy. In other words,
like the NEER, the REER is an index of a country's real exchange rate, a single number
which gives some reference or benchmark about how the currency is performing in relation
to the rest of the world as a whole, rather than just individual countries. Both these measures
are useful as benchmarks that give an idea of the general movement of the domestic
currency against the rest of the world. Theory tells us that if the domestic currency becomes
more expensive in terms of other currencies, then exports will become less valuable in terms
of the domestic currency and imports will become cheaper. The converse is true if the
domestic currency weakens (in nominal and real terms).