Q. Define Effective exchange rate?

Suppose that we are interested in external competitiveness of a country, let's say Japan. To do this we could look at evolution of a particular exchange rate, say exchange rate between the Japanese yen (JPY) and USD. The problem with this idea is that this exchange rate would reflect the external competitiveness and events in US as much as in Japan. If we want to isolate Japan without including events in other nations, we look at effective exchange rate instead.

Effective exchange rate is the price of a basket of currencies where every currency is weighted in relation to its significance to the country. Such a price level is then divided by a constant such that its value is exactly 100 at a given point in time. If, for instance, price index is 110 one year after the base year, then currency has depreciated by an average of 10% against other currencies that year.