With reference to the Indian economy, consider the following statements:
- An increase in 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 in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements is/are correct?
Ans (c) 1 and 3 only.
NEER is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency. It is a measure of value of currency against a weighted average of several foreign currencies. Therefore, an increase in NEER indicates the appreciation of the rupee. Statement 1 is correct.
Real Effective Exchange Rate is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs. REER is the weighted average of a country’s currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the index. An increase in REER implies that exports become more expensive and imports become cheaper. Therefore, an increase in REER indicates a loss in trade competitiveness. Hence, Statement 2 is incorrect.
The NEER is the weighted geometric average of the bilateral nominal exchange rates of the home currency in terms of foreign currencies. The REER is the weighted average of NEER adjusted by the ratio of domestic prices to foreign prices. Thus, an increasing trend in domestic inflation in other countries is likely to cause an increasing divergence between NEER and REER. Statement 3 is correct.