Question (Prelims 2022)

 

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?

 

Options

 

A. 2 and 3 only

 

B. 1 and 2 only

 

C. 1 and 3 only

 

D. 1, 2 and 3

 

Correct Answer : C. 1 and 3 only 

 

Explanation

 

The nominal effective exchange rate (NEER) is an unadjusted weighted average rate at which one country's currency exchanges for a basket of multiple foreign currencies, typically of major trading partners. 

 

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

 

The NEER may be adjusted to compensate for the inflation rate of the home country relative to the inflation rate of its trading partners. The resulting figure is the real effective exchange rate (REER). An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. So, statement 3 is correct.

 

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. Therefore, an increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. So, statement 1 is correct.

 

A higher NEER coefficient (above 1) means that the home country's currency is usually worth more than an imported currency, and a lower coefficient (below 1) means that the home currency is usually worth less than the imported currency.

 

An increase in the REER means an increase in inflation. Inflation is very harmful for imports and it will reduce a country's trade competitiveness. Therefore, an increase in the Real Effective Exchange Rate (REER) indicates a slide in trade competitiveness. So, statement 2 is incorrect. Hence, the correct answer is 1 and 3 only.

 

Source: Investopedia.com

 

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