NEER and REER relation with Export and Inflation UPSC pre 2022

 It was a theory question but a tough question and very random in nature.

 

The only way to do it in a real exam was the elimination method.

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

 

Solution - C

TRICK- An increase in a nation's REER indicates that its exports are becoming more expensive and its imports are becoming cheaper.

 

It is losing its trade competitiveness.

 

Statement 1-  An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of the rupee.

What is the Nominal Effective Exchange Rate (NEER)?

 

It is a measure of the value of a currency against a weighted average of several foreign currencies.

 

The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency.

 

If a domestic currency increases against a basket of other currencies inside a floating exchange rate regime, NEER is said to appreciate.

 

statement 2.  An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.

 What is the Real Effective Exchange Rate (REER)?

 

It is the real 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.

 

Concept- NEER VS REER

NEER, adjusted for inflation in the home country, equals its REER.

 

An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.

REER  take into account both nominal exchange rate changes and the inflation differential vis-à-vis trading partners.

 

Soaring inflation will impact REER, which, in turn, would inevitably push up the cost of the merchandise and affect the competitiveness of Indian exports.

Statement 3-  An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.

if inflation is in an increasing trend in the domestic nation relative to inflation in other countries, there is likely to cause an increasing divergence between NEER and REER.

 

The increasing difference between trends of NEER and REER in the last 2 years was due to India’s domestic inflation being higher relative to the six major currencies considered. 

Now let's revise the Concept using question