Q. With reference to the Indian economy, consider the following statements:
1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.
2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
3. 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?
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3
Correct Answer: c) 1 and 3 only
Question from UPSC Prelims 2022 GS Paper
Explanation :
Nominal Effective Exchange Rate (NEER) & Real Effective Exchange Rate (REER)
1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of the rupee.
This statement is correct. The NEER is an index that measures the value of a country’s currency relative to a basket of other major currencies, weighted by their relative trade with the country. An increase in NEER means that the Indian rupee has appreciated in value compared to this basket of currencies, which implies that it takes fewer rupees to buy the same amount of foreign currency.
2. An increase in Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
This statement is not necessarily correct. The REER adjusts the NEER for inflation differentials between India and its trading partners. An increase in REER suggests that the Indian currency has appreciated in real terms, which could make Indian exports more expensive and imports cheaper, potentially reducing trade competitiveness. However, it is also possible that an increase in REER reflects higher productivity or quality improvements in a country’s goods and services, which could enhance competitiveness. Therefore, an increase in REER does not unambiguously indicate an improvement in trade competitiveness.
3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
This statement is correct. If India experiences higher inflation than its trading partners, the NEER may not change much, but the REER will increase because the domestic currency’s real value is eroding due to higher prices. This divergence occurs because the REER is adjusted for inflation, while the NEER is not.
Given the explanations above, the correct answer is that statements 1 and 3 are correct, making the correct choice “1 and 3 only”.
