[Solved] With Reference to the Indian economy, consider the following statements: An increase in the National 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?

Q2) With Reference to the Indian economy, consider the following statements:

1. An increase in the National Effective Exchange rate (NEER) indicates the appreciation of the 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?

1. 1 and 2 only
2. 2 and 3 only
3. 1 and 3 only
4. 1, 2 and 3

Answer: c

• A weighted average of numerous foreign currencies is used to calculate the nominal effective exchange rate, or NEER.
• The amount of local currency required to buy foreign currency is known as the nominal exchange rate.
• In a system with variable exchange rates, NEER is said to appreciate if a domestic currency gains value relative to a basket of other currencies.
• The NEER depreciates if the local currency declines in value relative to the basket.
• Increases in NEER signify that the local currency has gained value relative to the weighted basket of currencies used by its trading partners.
• Real Effective Exchange Rate (REER) is the real effective exchange rate (a measure of a currency’s value versus a weighted average of multiple foreign currencies) divided by an index of costs or a price deflator.
• To put it simply, a country’s real effective exchange rate (REER) equals its nominal effective exchange rate (NEER), adjusted for inflation in the home country (REER).
• An increase in REER suggests a loss in trade competitiveness since it means that exports become more expensive and imports get less expensive.
• Using any metric of relative costs or prices, REER is the NEER after accounting for relative inflation (consumer price-based index); changes in the REER thus take into account both changes in the nominal exchange rate and the inflation differential with respect to trading partners.
• Rising inflation will have an effect on REER, which would certainly drive up the cost of goods and reduce the competitiveness of Indian exports.
• As a result, there is likely to be a growing disparity between NEER and REER if domestic inflation is increasing relative to inflation in other nations.

• The rising gap between NEER and REER trends is a result of India’s internal inflation rate being higher than the six major currencies taken into account

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