With reference to the Indian economy, consider the following statements:An increase in Nominal Effec

Question

With reference to the Indian economy, consider the following statements:An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of 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?

Accepted Answer

Nominal Effective Exchange Rate (NEER) 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. If the domestic currency falls against the basket, the NEER depreciates. An increase in NEER indicates an appreciation of the local currency against the weighted basket of currencies of its trading partners. Hence, statement 1 is correct.Real Effective Exchange Rate (REER) 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. In simple words, a nation's nominal effective exchange rate (NEER), adjusted for inflation in the home country, equals its real effective exchange rate (REER). 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.REER is the NEER after factoring in relative inflation (consumer price-based index) using some measure of relative prices or costs; changes in the REER thus 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 merchandise and affect competitiveness of Indian exports. Thus, if inflation is in an increasing trend in domestic nation relative to inflation in other countries, there is likely to cause an increasing divergence between NEER and REER.For instance, considering NEER and REER values between April 2019 and May 2021 in India, the NEER has been mostly declining, whereas, REER remains in sync with the inflationary trends—the upward biases in REER due to inflation was already being felt in May 2021. The increasing difference between trends of NEER and REER in the last 26 months was due to India’s domestic inflation being higher relative to the six major currencies considered. Hence, statement 3 is correct.Source Attribution: Investopedia, Financial Express