# **I. Measuring the Real Effective Exchange Rate (REER)**

In a small-open economy the real exchange rate may be its most important relative price measure and can be used as a key indicator of the economy’s external competitiveness. There are numerous ways to measure the real exchange rate and the choice of measure depends on the analytic question under investigation and data availability to empirically measure it. The analytic framework used to derive the real exchange rate in this paper is the two-sector dependent economy framework developed by Salter (1959) and Swan (1960). In this framework the relative domestic price of nontraded to traded goods _within_ the country is the real exchange rate. It is the relative price that achieves internal balance in the domestic supply and demand of nontraded and traded goods and captures the _internal_ relative price incentives in an economy for producing or consuming tradable or nontradable goods (Hinkle and Nsengiyumva 1999). This measure has particular appeal in the low-income country (LIC) context and has been widely used in empirical real exchange rate studies (e.g. Van Wijnbergen (1985), Edwards (1989) and Elbadawi and Soto (2005)).

In principle, the domestic price indices of tradables and nontradables should be used to construct the _internal_ RER, but these series are typically not available in LICs. In practice, the _internal_ real exchange rate is measured using the foreign WPI and the domestic CPI. The foreign WPI multiplied by the nominal exchange rate proxies the home country’s tradable goods price, while the domestic CPI is a proxy for nontradable prices in the home economy.<sup>2</sup> A key drawback in using the CPI as a proxy for nontradables prices is that the greater the weight of traded goods in the CPI implies a greater divergence in the proxy to nontraded goods prices. An important drawback in using foreign WPI is that it is unlikely to track fluctuations in a LIC’s exports prices, especially commodity prices. It may, however, do better tracking import prices and nontraditional exports. One alternative is to calculate a domestic tradables price index by taking a weighted average of the foreign price of importables ( _PMd_ ) and exportables 3 ( _PXd_ ) multiplied by the nominal exchange rate as in equation one.

> 2 One direct measure includes using expenditure data from nation accounts to measure the ratio of domestic prices of goods actually exported and imported and the price of domestically produced and consumed goods (Devarajan, Lewis and Robinson 1993). Another direct measure attempts to split sectors of production into tradable and nontradable categories and then calculate implicit price deflators.

> 3 This measure of the internal real exchange rate implicitly assumes that import prices and export prices move together so that they can be aggregated into one tradable goods price. If the price of imports and export diverge then the measure will be less likely to appropriately capture the price incentives of producing or consuming tradables. In this case, it may be more appropriate to consider separate internal RER indices, one using exports prices and the other using import prices. In this way, the incentives in the exportable or the import-substituting sectors are better represented by the separate indices.

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