UPSC Prelims 2022 Question:

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:

• 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. 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. So, statement 1 is correct.
  
  

• The Real Effective Exchange Rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against that of each country in the index. An increase in a nation's REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper. This results in losing its trade competitiveness. So, statement 2 is not correct.
  
  
• REER remains in sync with the inflationary trends—the upward biases in REER due to inflation was recently seen in India. An increase in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. The increasing difference between trends of NEER and REER in recent times was due to India’s domestic inflation being higher relative to the six major currencies considered. So, statement 3 is correct.
  
  

Therefore, option (3) is the correct answer.

Subject: Economics| National Income Accounting