TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 15

Nominal and Real Effective Exchange Rates

(NEER and REER)
They are basically exchange rate indices
India trade with many countries
INR can be expected to be appreciated with some currency or
depreciated with respect to some other currency

Nominal Effective Exchange Rates (NEER)

The weighted average of bilateral nominal exchange rates of the home
currency in terms of foreign currencies.
The weights are determined by the importance a home country places on
all other currencies traded within the pool, as measured by the balance of
trade.
NEER (6 currency: Indian rupee is measured against 6 big currencies, Dollar
Hong Kong dollar, Euro, Pound sterling, Japanese Yen, Chinese Renminbi)

Real Effective Exchange Rates (REER)

REER is the weighted average of nominal exchange rates, adjusted for
inflation.
It is an index of a country's real exchange rate, a single number which gives
some reference or benchmark about trade competitiveness in relation to
the rest of the world as a whole, rather than just individual countries.
If the REER > 100, then Indian goods are relatively less competitive in
the export market and vice versa.

Source : RBI

Continuum of exchange rate regimes

Free float

FLEXIBLE REGIMES
Managed float
INTERMEDIATE REGIMES

Crawling peg

Currency board

Basket peg
FIXED REGIMES
Dollarization/Euronization

Adjustable peg

Monetary union

Flexible Exchange Rates

In a flexible (floating) exchange rate system, central banks allow the
exchange rate to adjust to equate the supply and demand for foreign
currency
Free float
Managed float

Flexible Exchange Rates: Advantages

Deficit or surplus in BOP is automatically corrected

There is no need for government to hold any foreign exchange
reserve
It helps in optimum resource allocation
Promotes International Trade
Monetary independence

Flexible Exchange Rates: Disadvantages

Higher volatility: Unstable conditions
Wide fluctuation in exchange rate hampers foreign trade and capital
movement between countries
Tendency to worsen existing problems

Intermediate Regime
Crawling peg
Basket-of-currencies
Pegged within a band

Fixed Exchange Rates

In a fixed exchange rate system foreign central banks stand ready to buy
and sell their currencies at a fixed price in terms of dollars.
Central banks hold reserves to sell when they have to intervene in the
foreign exchange market.

Currency boards
Dollarization/Euroization
Monetary union

Fixed Exchange Rates

Involves intervention from central bank
The balance of payments measures the amount of foreign exchange intervention
needed from the central banks

What determines the level of intervention of a central bank in a fixed

exchange rate system?
As long as the central bank has the necessary reserves, it can continue to
intervene in the foreign exchange markets to keep the exchange rate constant
If a country persistently runs deficits in the balance of payments:
The central bank eventually will run out of reserves on of foreign exchange
Will be unable to continue its intervention
Before this occurs, the central bank will likely devalue the currency

Fixed Exchange Rates: Advantages

It ensures stability in exchange rate which encourages foreign trade

Avoid competitive depreciation (currency wars)
Stability encourages investment
Fixed exchange rates are more conducive to expansion of world
trade because it prevents risk and uncertainty in transactions
It prevents speculation in foreign exchange market

Fixed Exchange Rates: Disadvantages

Conflict with other objectives
Benefits of free markets are deprived
There is always possibility of under-valuation or over-valuation

Exchange rate system in India

India was among the original members of the IMF when it started
functioning in 1946. India adopted the Bretton Woods system of exchange
rate determination
The Bretton Woods system collapsed in 1971. Pegged system
However, the need for adjusting exchange rate became precipitous in the
face of external payments crisis of 1991

As a part of the overall macro-economic stabilization programme, the

exchange rate of the rupee was devalued in two stages by 18 per cent in
terms of the US dollar in July 1991

 During the period 1947 till 1971, India followed the par value system of the
exchange rate whereby the rupees external par value was fixed at 4.15
grains of fine gold

With the breakdown of the Bretton Woods System, in December 1971, the
rupee was linked with pound sterling.
The currencies included in the basket as well as their relative weights were
kept confidential by the Reserve Bank to discourage speculation
BOP crisis in 1990 resulted in market determined (managed float) exchange
rate regime.

Features of the Current Regime

The rates of exchange are determined in the market.
The freely floating exchange rate regime continues to operate within the
framework of exchange control.
RBI can intervene in the market to modulate the volatility and sharp
depreciation of the rupee. It effects transactions at a rate of exchange,
which could change within a margin of 5 per cent of the prevailing market
rate.
The US dollar is the principal currency for the RBI transactions

 Devaluation of Yuan
http://www.bloomberg.com/news/articles/2015-08-23/china-ledemerging-market-turmoil-evokes-worrisome-1994-parallel

http://www.bloomberg.com/news/articles/2015-08-11/chinaweakens-yuan-reference-rate-by-record-1-9-amid-slowdown