What does an increase in real effective exchange rate indicate?

The Impact of an Increasing Real Effective Exchange Rate (REER) on a Nation’s Economy

The real effective exchange rate (REER) is a measure of the value of a nation’s currency against a weighted average of the currencies of its major trading partners, adjusted for inflation. An increase in the REER indicates that a nation’s currency has appreciated, or become more expensive, relative to the currencies of its trading partners.

This appreciation of the currency can have significant implications for the nation’s economy. Primarily, it affects the competitiveness of exports and the attractiveness of imports.

Impact on Exports

When the REER increases, the domestic currency becomes more expensive relative to foreign currencies. This makes exports more expensive for foreign buyers, as the prices are higher when converted to their own currencies. As a result, exports become less competitive in international markets, leading to a decline in export demand.

Impact on Imports

Conversely, an increase in the REER makes imports more attractive. Since the domestic currency is more expensive, foreign goods and services become cheaper when converted to the local currency. This encourages an increase in imports, as domestic consumers and businesses can purchase foreign products at lower prices.

Net Effect on Net Exports

The combined effects of reduced exports and increased imports result in a decline in net exports. Net exports are the difference between the value of a nation’s exports and imports. A decrease in net exports can lead to a number of economic consequences, including:

• Reduced economic growth, as the decline in exports can slow down the overall growth of the economy.
• A widening trade deficit, as the value of imports exceeds the value of exports.
• Pressure on the nation’s balance of payments, as the outflow of funds for imports exceeds the inflow of funds for exports.

Other Impacts

In addition to the direct effects on exports and imports, an increase in the REER can also affect other aspects of the economy, such as:

• Inflation: A decline in net exports can lead to lower inflation, as imported goods become cheaper and put downward pressure on domestic prices.
• Interest rates: Central banks may lower interest rates to stimulate economic growth and counterbalance the negative effects of a high REER on exports.
• Investment: A lower REER can make it more attractive for foreign investors to invest in the nation, as they can acquire domestic assets at a cheaper cost in their own currencies.

In conclusion, an increase in the real effective exchange rate can have significant implications for a nation’s economy. By making exports less competitive and imports more attractive, it leads to a decline in net exports, which can have adverse effects on economic growth, the trade deficit, and other macroeconomic variables.