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 ?

Test your knowledge of NEER and REER in the Indian economy. Understand how exchange rates and inflation impact trade competitiveness. Choose the correct options.

The correct answer is 1 and 3 only.

Key Points

Nominal Effective Exchange Rate (NEER):

• It 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 the value of a currency against a weighted average of several foreign currencies. An increase in NEER indicates an appreciation of the rupee. Hence, Statement 1 is correct.

Real effective exchange rate (REER):

• It 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 that of each country in the index.
• An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness. Hence, Statement 2 is not correct.
• The NEER is the weighted geometric average of the bilateral nominal exchange rates of  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.
• An increasing trend in domestic inflation relative to inflation in other countries creates a divergence in NEER and REER. Hence, Statement 3 is correct.

• NEER is like a report card for a country's currency. It shows how strong or weak a currency is compared to a bunch of other currencies. Imagine you're comparing how well your favorite sports team is doing against all the other teams in the league - that's kind of what NEER does for currencies!

  Here's what makes NEER special:

• It looks at multiple currencies, not just one

• It uses a weighted average, giving more importance to countries that trade more with each other

• It doesn't account for inflation (that's why it's called "nominal")