Question
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?
Explanation
Correct answer: (c) 1 and 3 only
Statement 1 is correct: The Nominal Effective Exchange Rate (NEER) is an unadjusted, weighted average of the rupee’s bilateral nominal exchange rates against a basket of foreign currencies. A rise in NEER means the rupee has appreciated in nominal terms.
Statement 2 is incorrect: The Real Effective Exchange Rate (REER) is NEER adjusted for the inflation differential with trading partners. A rise in REER means Indian goods have become relatively more expensive abroad — that’s a loss, not an improvement, in trade competitiveness.
Statement 3 is correct: Since REER = NEER adjusted for the inflation gap, if domestic inflation runs faster than foreign inflation, the adjustment multiplier grows, and the gap between NEER and REER widens.