Adjusted exchange rate

What Is Adjusted Exchange Rate?

An adjusted exchange rate is a measure of a currency's value that has been modified to account for differences in price levels or inflation between countries. It falls under the broader category of International Finance, providing a more accurate representation of a currency's purchasing power and a nation's trade competitiveness than simple nominal exchange rates. The most common form of an adjusted exchange rate is the Real Effective Exchange Rate (REER), which considers a country's currency value against a weighted average of the currencies of its major trading partners, adjusted for relative inflation rates¹⁰. This adjustment helps analysts assess whether a country's goods and services are becoming more or less expensive relative to those of its trading partners, influencing the Trade Balance.

History and Origin

The concept of adjusting exchange rates for price differences has evolved with the increasing interconnectedness of global economies. While bilateral nominal exchange rates have always been observed in the Foreign exchange market, the need for a comprehensive measure reflecting true competitiveness became more apparent after the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s. As currencies began to float more freely, the impact of varying domestic price changes on international trade became a critical area of study for economists and policymakers. Institutions like the International Monetary Fund (IMF) have played a significant role in developing and standardizing methodologies for calculating effective exchange rates, including the real effective exchange rate, to aid in surveillance and policy analysis for its member countries. The IMF, for instance, provides extensive data and analysis on effective exchange rates, highlighting their importance in assessing a country's external position and competitiveness⁸, ⁹. The IMF's role shifted significantly after 1971, moving towards monitoring economic policies and providing financial stability, with exchange rate analysis remaining a core function. IMF Factsheet - Exchange Rate Policies

Key Takeaways

• An adjusted exchange rate, commonly the Real Effective Exchange Rate (REER), accounts for inflation differences between a country and its trading partners.
• It provides a more accurate picture of a nation's international competitiveness than nominal exchange rates.
• An increase in a country's adjusted exchange rate generally indicates a loss of trade competitiveness, making its exports more expensive and imports cheaper.
• Policymakers and analysts use adjusted exchange rates to inform decisions regarding trade policy, monetary policy, and exchange rate management.
• The calculation involves weighting bilateral exchange rates by the trade share with each partner and adjusting for relative price levels.

Formula and Calculation

The Real Effective Exchange Rate (REER) is typically calculated using the following formula:

$\text{REER} = \text{NEER} \times \frac{P^*}{P} \times 100$

Where:

• (\text{REER}) = Real Effective Exchange Rate Index
• (\text{NEER}) = Nominal Effective Exchange Rate Index, which is a weighted average of the bilateral Nominal Exchange Rate of the home country's currency against a basket of foreign currencies⁷.
• (P^*) = Weighted average of foreign price levels (e.g., Consumer Price Index or Producer Price Index) of trading partners⁶.
• (P) = Domestic price level (e.g., Consumer Price Index or Producer Price Index)⁵.
• 100 = A scaling factor to express the REER as an index, often with a base year set to 100⁴.

The weights for both the nominal exchange rates and the foreign price levels are determined by the relative shares of trade (both Exports and Imports) a country conducts with its trading partners.

Interpreting the Adjusted Exchange Rate

Interpreting the adjusted exchange rate involves understanding its implications for a country's economic standing, particularly in the realm of International Trade. An increase in the adjusted exchange rate indicates that the domestic currency has appreciated in real terms. This means that, after accounting for inflation differences, a country's goods and services have become more expensive for foreign buyers and foreign goods and services have become cheaper for domestic buyers. Such a development can lead to a decrease in exports and an increase in imports, potentially worsening the country's Trade Deficit and reducing its international competitiveness. Conversely, a decrease in the adjusted exchange rate signifies a real depreciation of the domestic currency, making exports more attractive and imports less so, which can boost trade competitiveness.

Hypothetical Example

Consider a hypothetical scenario involving "Country A" and its main trading partner, "Country B."
Suppose, in a base year, the adjusted exchange rate index for Country A is 100.
Over the next year, Country A's nominal exchange rate against Country B's currency remains stable. However, Country A experiences 5% inflation, while Country B has 2% inflation.

To calculate the new adjusted exchange rate for Country A relative to Country B, we can simplify the REER formula for a bilateral case:

Initial REER = 100
Nominal Exchange Rate (NEER, bilateral) = 1 (assuming it stays constant)
Initial Domestic Price (P) = 100
Initial Foreign Price (P*) = 100

After one year:
New P (Country A's inflation) = 100 * (1 + 0.05) = 105
New P* (Country B's inflation) = 100 * (1 + 0.02) = 102

Using the formula:
$\text{Adjusted Exchange Rate} = 1 \times \frac{102}{105} \times 100 \approx 97.14$

In this example, even though the nominal exchange rate didn't change, the adjusted exchange rate for Country A decreased from 100 to approximately 97.14. This real depreciation suggests that Country A's goods have become relatively cheaper compared to Country B's, potentially enhancing Country A's export competitiveness. This is distinct from a deliberate Currency Devaluation, which involves a government action to lower its currency's fixed value.

Practical Applications

Adjusted exchange rates are crucial tools for economists, policymakers, and investors in various real-world applications. Central banks and governments closely monitor these rates to assess the impact of their Monetary Policy and Fiscal Policy on trade competitiveness and overall Economic Growth. For instance, a country experiencing a sustained appreciation of its adjusted exchange rate might consider policy interventions to prevent a significant loss of export market share.

Additionally, businesses involved in international trade use these metrics to make strategic decisions about pricing, sourcing, and market entry. Investors analyze adjusted exchange rates to gauge a country's economic health and potential returns on foreign investments, as movements in these rates can significantly impact the profitability of international ventures. For example, recent discussions around China's currency, the yuan, and its potential depreciation highlight how exchange rate adjustments can be used in response to trade policies, though their effectiveness in fully offsetting large tariffs can be limited. Market Insight: 'Difficult' for China to offset potential tariff with currency moves

Limitations and Criticisms

While adjusted exchange rates provide valuable insights, they also have limitations. One common criticism relates to the selection of appropriate price indices (e.g., Consumer Price Index, Producer Price Index, or Unit Labor Costs) for the adjustment, as different indices can yield varying results and may not fully capture all competitive aspects³. Data quality and availability for comprehensive and timely price comparisons across numerous trading partners can also be a challenge.

Furthermore, the impact of an adjusted exchange rate change on a country's Balance of Payments or trade flows is not always immediate or straightforward. Economic theory suggests that a real depreciation should improve the trade balance, but the "J-curve effect" illustrates that initially, the trade balance might worsen before improving as trade volumes react with a lag¹, ². Other factors, such as the elasticity of demand for exports and imports, supply-side constraints, and global economic conditions, can also influence the actual outcome. Countries also face Exchange Rate Risk regardless of whether they track nominal or adjusted rates. The Federal Reserve Bank of San Francisco, like other central banks, continually analyzes complex economic interactions, underscoring the nuanced nature of exchange rate dynamics. Federal Reserve Bank of San Francisco

Adjusted Exchange Rate vs. Nominal Exchange Rate

The key distinction between an adjusted exchange rate and a Nominal Exchange Rate lies in the incorporation of price level differences. A nominal exchange rate simply states how much of one currency can be exchanged for another. For example, if 1 US Dollar (USD) equals 0.90 Euro (EUR), this is a nominal exchange rate. It tells you the conversion rate at a specific point in time without considering what that money can actually buy in each country.

An adjusted exchange rate, particularly the Real Effective Exchange Rate (REER), goes a step further by taking into account the relative purchasing power of those currencies. It factors in inflation rates between countries, providing a measure of a currency's value in terms of its ability to purchase goods and services. Therefore, while a nominal exchange rate might remain constant, an adjusted exchange rate can change significantly if the inflation rates in the two countries diverge. The adjusted rate offers a more meaningful assessment of a country's trade competitiveness and the real cost of its goods and services on international markets, whereas the nominal rate is merely the quoted market price.

FAQs

What does it mean if a country's adjusted exchange rate is increasing?

An increasing adjusted exchange rate, or real appreciation, means that a country's domestic goods and services are becoming relatively more expensive compared to those of its trading partners. This can make its Exports less competitive and its Imports cheaper, potentially leading to a larger Trade Deficit.

How do central banks use adjusted exchange rates?

Central banks use adjusted exchange rates as key indicators to assess international competitiveness and inform their Monetary Policy decisions. They monitor these rates to understand the impact on inflation, trade flows, and economic stability, and to guide interventions in the foreign exchange market if deemed necessary.

Is the adjusted exchange rate related to Purchasing Power Parity?

Yes, the concept of adjusted exchange rates, especially the real exchange rate, is closely related to Purchasing Power Parity (PPP). PPP suggests that exchange rates between currencies should equalize the purchasing power of those currencies in different countries. The real exchange rate essentially measures deviations from PPP, indicating whether goods and services in one country are more or less expensive than comparable goods and services in another, after converting currencies.

What factors can influence an adjusted exchange rate?

Many factors can influence an adjusted exchange rate. These include differences in national Interest Rates, relative inflation rates, economic growth differentials, trade policies, capital flows, and market speculation. Any factor that affects either the nominal exchange rate or the relative price levels between a country and its trading partners will impact the adjusted exchange rate.

How does currency devaluation affect adjusted exchange rates?

Currency Devaluation, which is a deliberate downward adjustment of a currency's value, directly impacts the nominal exchange rate component of the adjusted exchange rate. If a country devalues its currency, assuming other factors remain constant, its adjusted exchange rate would typically decrease (a real depreciation), making its exports cheaper and potentially improving its trade balance.