Effective Exchange Rate

First, we need to explain that a bilateral exchange rate is the exchange rate between only two currencies: the dollar against the euro, the British pound against the Japanese yen, etc.

Looking at the bilateral exchange rates gives us useful information but we may want to know how the value of a currency is changing with respect to all other currencies.

For that we use the effective exchange rate which is an average of the bilateral exchange rates. A currency may be appreciating against some currencies and depreciating against other currencies at the same time. The effective exchange rate tells us the overall direction and magnitude of change. If the effective exchange rate appreciates/depreciates then we know that the currency is appreciating/depreciating against a basket of the other currencies.

The effective exchange rate is a weighted average. As weights we use the volume of international trade between two countries. The greater the trade between two countries, the greater the weight in their effective exchange rates. Computed that way, the effective exchange rate reflects what is important to that particular country in terms of international trade.