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Bilateral vs. effective exchange rate

Bilateral vs. effective exchange rate
Published:   12 Dec at 9 AM

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The bilateral exchange is the common
way of quoting a currency in that it involves two currencies in a pair.
The majority of the time the central or federal bank will be one side
of the relationship and they are displayed using their three letter
symbols and are displayed with the base currency at the beginning followed
by another currency for example, USD/GBP where the United States Dollar
is the base currency. However, the effective exchange rate which is
commonly known as the Trade Weighted Index, is considered to be a much
more comprehensive way of analysing two economies and is a multilateral
exchange rate which is a weighted average of a collection of international
currencies and is generally seen as a giving a good overall view of
a nations external competitiveness. These exchange rates are computed
for judging the general dynamics of a country's currency toward the
rest of the world. In simply put words, one will take a basket of different
currencies, select a meaningful set of relative weights, and then compute
the "effective" exchange rate of that country's currency.

The exchange rate is essentially
a multilateral exchange rate which is designed to represent the weighted
average of the various exchange rates with both domestic and abroad
currencies with the foreign currency being the same as that nations
share in trade, hence the term Trade Weighted Index. Generally speaking,
the Trade Weighted Index is a way for a nation to view their currency
exchange rate in comparison to other leading countries. Country's
that account for a bigger chunk of the economy's export and imports
are given a higher index.

Another way of assessing is by using
a nominal effective exchange rate (NEER) which is weighted with the
inverse of the asymptotic trade weights.A real effective exchange rate
(REER) adjust NEER by appropriate foreign price level and deflates by
the home country price level. Compared to NEER, a GDP weighted effective
exchange rate might be more appropriate considering the global investment
phenomenon. The interpretation of the effective exchange rate is that
if the index increases, the purchasing power of that currency is higher
(the currency strengthened against those of the country's or area's
trading partners). A lower index means that the currency depreciated
(devaluation) so that you need more of that currency to pay for imports.

The vast majority of nations are
typically believed to be imposing more than one exchange rate, depending
on the kind of transaction and the subjects involved in the transaction.
Depending on the commercial vs. public transactions or consumption and
investment imports, one can see multiple exchange rates existing. So
the Bilateral vs Effective Exchange Rate title of this section is not
so much a competition between the two but more often that not
for most countries, a combination of the two.

« Exchange Rates - What are they and how are they calculated?

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