With reference to the Indian economy, consider the following statements:
- An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.
- An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
- An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements are correct?
Detailed Explanation:
Answer: Option 3 — 1 and 3 only
This question tests the understanding of exchange rate indices and their relationship with inflation and trade competitiveness. Statement 2 is incorrect because an increase in REER indicates overvaluation of the currency, which actually worsens (not improves) trade competitiveness.
✅ Statement 1 – Correct: NEER is a weighted average of a country's currency against a basket of trading partner currencies. An increase in NEER indicates that the domestic currency has appreciated relative to the basket of foreign currencies.
❌ Statement 2 – Incorrect: An increase in REER indicates that the domestic currency is becoming overvalued in real terms (after adjusting for inflation differentials), which reduces export competitiveness and worsens trade competitiveness, not improves it.
✅ Statement 3 – Correct: When domestic inflation is higher than foreign inflation, the real value of the currency depreciates faster than the nominal value. This causes REER to decline or grow slower than NEER, creating a divergence between the two indices.
📝 Short Notes: NEER and REER
- NEER (Nominal Effective Exchange Rate): Weighted average of bilateral nominal exchange rates of home currency against a basket of foreign currencies; measures nominal appreciation/depreciation without considering inflation.
- REER (Real Effective Exchange Rate): NEER adjusted for relative price levels (inflation differentials); measures real appreciation/depreciation and actual competitiveness.
- Formula relationship: REER = NEER × (Domestic Price Index / Foreign Price Index)
- Appreciation vs Competitiveness: If REER increases → currency overvalued → exports become expensive → trade competitiveness worsens; If REER decreases → currency undervalued → exports become cheaper → trade competitiveness improves.
- Inflation Impact: Higher domestic inflation relative to trading partners causes REER to rise faster than NEER (real appreciation), reducing competitiveness.
- Policy Implication: RBI monitors both NEER and REER; a rising REER signals loss of export competitiveness and may require policy intervention.
Question 1 of 12 Balance of Payments
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