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 ?
1 and 2 only
2 and 3 only
1 and 3 only
1, 2 and 3
Answer is Wrong!
Answer is Right!
This question was previously asked in
UPSC IAS – 2022
Statement 2 is incorrect. Real Effective Exchange Rate (REER) is NEER adjusted for the inflation differential between the domestic economy and its trading partners. REER = NEER * (Domestic Price Index / Foreign Price Index). An increase in REER means that the domestic country’s goods and services are becoming relatively more expensive compared to those of its trading partners. This makes exports less competitive and imports more attractive, thus indicating a *decrease* (or worsening) in trade competitiveness.
Statement 3 is correct. The formula for REER shows its relationship with NEER and inflation differentials. REER = NEER * (Domestic Price Index / Foreign Price Index). If domestic inflation increases significantly relative to foreign inflation, the term (Domestic Price Index / Foreign Price Index) increases. This will cause the REER to rise relative to the NEER. For instance, if NEER remains constant, an increase in domestic inflation relative to foreign inflation will cause REER to increase, creating a divergence. Similarly, if NEER depreciates, but domestic inflation is much higher, REER might depreciate less or even appreciate, again creating divergence.