The real effective exchange rate (REER) is an important input in determining market intervention when nominal exchange rates tend to show volatility.
The Indian rupee’s REER shows that the currency was overvalued by over four percent in June when it was hovering around 79 to a dollar. Since then, the rupee has weakened further close to 80 per dollar this month and the overvaluation may have reduced a bit.
The REER is calculated by taking the rupee’s value against a basket of 40 currencies weighted by their trade with India. In a nutshell, it captures the competitiveness of the rupee against that basket.
Inflation tends to reduce this competitiveness. Rising inflation erodes the value of the currency which brings us to the unusual situation where price increases in the US is greater than that of India.
Inflation erodes the value of the currency of the economy but the relationship is not that straight forward. Note in the above chart that inflation in India was low during FY20 but the REER of the rupee put a significant overvaluation during that time.
Also, the rupee has risen against other currencies such as the euro, the pound sterling, and its losses against the dollar are modest compared with other Asian peers. The REER captures these differences and therefore is a better indicator of an exchange rate’s outlook than other economic factors.
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