Indices Of Effective Exchange Rates: A Comparative Study Of Ethiopia, Kenya And The Sudan

The paper considers the various indices of effective exchange rate that are applied in many countries to measure the overvaluation or undervaluation of a particular currency compared to the currency of major trading countries. First the conceptual issues of the nominal effective exchange rate (NEER) is considered. In general there are three types of nominal effective exchange rates namely the export weighted, import weighted and trade weighted rates. Other indices may also be developed on the basis of the three indices. The major drawback with these rates is that they do not isolate the effect of overvaluation from possible inflationary differentials between reporting countries and major trading partners. In order to isolate the pure exchange rate effect, the nominal effective exchange rate should be deflated by the ratio of the inflation rate of a reporting country to that of a partner country. This would in turn give us the Real Effective Exchange Rate (REER). There are two problems associated with the conversion of NEER to REER. First, there is an issue of what type of price index to use. There are several indices including the Consumer Price Index (CPI), the wholesale price index (WPI), as well as other related indices. Second, even if a particular index is chosen, that index may not be measured in a similar manner between the two countries. If the Real Effective Exchange Rate (REER) is measured with minimal error then such an index may be a measure of changes in the price of tradables compared to non-tradables. In other words, the REER is akin to the Real Exchange Rate (RER).