From Indian Economy Mindmap Notes » External Sector in India
The effective exchange rate is the exchange rate of a monetary zone, measured as the weighted sum of the exchange rates with trading partners and competitors.
The nominal effective exchange rate is measured with the nominal parts (therefore without taking into consideration of the differences in purchasing power between the two currencies), while the real effective exchange rate has price indices and their trends.
Example: The nominal effective exchange rate of the euro for France is a weighted mean (with the weighting being specific to France) of the exchange rates of the euro against the currencies of the competing countries in a given zone (OECD, for example). The weighting of the exchange rate in relation to a country in the zone includes the market share of France in this country and the market shares of this country and of France in each of the third-party markets. The real effective exchange rate of the euro for France includes the exchange rate but also the ratio of France’s export prices to those of competing countries in the zone under consideration.
A rise in the nominal (resp. real) effective exchange rate corresponds to a deterioration in exchange (resp. price) competitiveness.