Previous Year Question
With reference to the Indian economy, consider the following statements:
An increase in the Nominal Effective Exchange Rate (NEER) indicates the appreciation of the 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?
1 and 2
2 and 3
1 and 3
1, 2 and 3
Correct Answer: C
Detailed Solution
A bilateral exchange rate with one foreign currency indicates the position of the rupee only against that particular currency. NEER and REER, in contrast, measure the overall position of the rupee by assigning specified trade weights to the currencies of India’s major trading partners.
What is NEER?
The Nominal Effective Exchange Rate is the trade-weighted geometric average of the bilateral nominal exchange rates of the domestic currency against several foreign currencies.
In the RBI’s NEER index:
currencies of India’s major trading partners are included;
each currency receives a weight according to its importance in India’s trade;
an increase in the index represents nominal appreciation of the rupee; and
a decline in the index represents nominal depreciation of the rupee.
Statement 1 is correct.
If NEER increases from 100 to 105, it generally means that the rupee has appreciated by approximately 5% on a trade-weighted basis. It does not necessarily mean that the rupee has appreciated against every individual foreign currency; it represents the overall movement against the weighted currency basket.
What is REER?
The Real Effective Exchange Rate adjusts NEER for the relative inflation or price differential between India and its trading partners.
In simplified form:
A change in REER may consequently arise from:
a change in the rupee’s nominal exchange rate; or
a difference between inflation in India and inflation in its trading partners.
Statement 2 is incorrect.
An increase in REER generally represents a real appreciation of the domestic currency. It indicates that Indian goods are becoming relatively more expensive than foreign goods.
Consequently:
the price competitiveness of Indian exports may decline;
imports may become relatively cheaper; and
exporters’ profit margins may come under pressure.
Therefore, an increase in REER does not indicate an improvement in trade competitiveness. It generally indicates a loss of trade competitiveness. Actual export performance, however, is also affected by productivity, quality, logistics and global demand.
Statement 3 is correct.
NEER measures only nominal exchange rates, whereas REER also incorporates relative inflation. If inflation in India remains higher than inflation in its trading partners, REER may increase even when the nominal exchange rate remains unchanged.
For example, assume that:
NEER remains unchanged at 100;
India’s price index increases from 100 to 108; and
the price index of its trading partners increases from 100 to 103.
Under a simplified calculation:
In this example, NEER remains at 100, but REER increases to approximately 104.85. A divergence of approximately 4.85 index points arises because of relatively higher domestic inflation.
Thus, higher inflation in India relative to other countries can create an increasing divergence between NEER and REER.