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Getting Exchange Rates Right

Standard calculations of a country’s real effective exchange rate (REER) ignore global value chains that spread production processes across countries. Taking this factor into account leads to more accurate REER calculations, which can have profound policy implications.

NEW YORK – The real effective exchange rate (REER) may sound arcane to non-economists, but it is one of the most important international financial indices. The REER is a summary index that tracks the difference in the prices of goods produced by a country and its trading partners. Other things being equal, an increase in a country’s REER indicates a loss of trade competitiveness. And rising current-account imbalances are often associated with deviations in the REER from equilibrium values.

Given the REER’s importance for economic policy – in the current trade discussions between the United States and China, for example – central banks and international financial institutions devote considerable resources to calculating and analyzing it. But their methods have become outdated as global value chains (GVCs) become increasingly widespread. We therefore recently proposed a new REER calculation with Zhi Wang that addresses the current shortcomings.

Standard calculations of the REER by most central banks and statistical agencies assume that countries export only final goods. But GVCs spread the different stages of production among different countries. They can do so thanks to technological improvements, lower trade barriers, and the closer integration of emerging markets into the global economy. Ignoring this reality can lead to substantial mismeasurement of the REER, resulting in questionable policy inferences.

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