Relevance: GS Paper 3, Indian Economy
Q. 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?
[A] 1 and 2 only
[B] 1 and 2 only
[C] 1 and 3 only
[D] 1, 2 and 3
Answer: C
NEER and REER are two measures of a country’s exchange rate against the currencies of its trading partners. They help to determine whether a currency is overvalued or undervalued in relation to other currencies.
NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) are used to calculate the relative strength of a country’s currency against the currencies of its trading partners.
NEER measures the value of a currency against a basket of currencies of a country’s trading partners. In contrast, REER measures the value of a currency against the same basket of currencies adjusted for inflation.
Here’s a table explaining the difference between NEER and REER using India as an example:
| Exchange Rate Measure | Calculation Method | Example |
| NEER (Nominal Effective Exchange Rate) | Weighted average of bilateral exchange rates | NEER of India = (0.10 x USD) + (0.10 x Euro) + (0.15 x Pound) + (0.05 x Yen) + (0.60 x Yuan) |
| REER (Real Effective Exchange Rate) | NEER adjusted for inflation | REER of India = (NEER of India x Domestic Price level) / (Foreign Price level) |
Formulae for NEER and REER:
NEER = Σ(wi * ei)
where, wi = weight of ith trading partner’s currency in the basket ei = bilateral exchange rate of the domestic currency with ith trading partner’s currency
REER = (NEER * Domestic Price level) / (Foreign Price level)
where, Domestic Price level = weighted average of prices of goods and services in the domestic economy Foreign Price level = weighted average of prices of goods and services in the foreign economies
When NEER and REER are above 100, it means that the domestic currency is overvalued, and when they are below 100, it means that the domestic currency is undervalued.
In such situations, domestic exporters find it difficult to sell their products abroad, as foreign buyers find them more expensive due to the overvalued currency. On the other hand, when the domestic currency is undervalued, domestic products become cheaper for foreign buyers, leading to an increase in exports.
In the Indian context, when the NEER and REER move above 100, it becomes more challenging for Indian exporters to sell their products abroad as foreign buyers find them more expensive. As a result, it leads to a decline in exports, which affects the country’s economy.
Similarly, when NEER and REER are below 100, it becomes easier for Indian exporters to sell their products abroad, leading to an increase in exports, which boosts the country’s economy.
In NEER and REER, the number 100 is used as a benchmark or base value to compare the value of a country’s currency to a basket of currencies of its trading partners. A value above 100 means that the currency is stronger, while a value below 100 indicates that the currency is weaker.
Let’s take an example to understand this better. Suppose India’s NEER is calculated as 105, and its REER is calculated as 110.
This means that the Indian rupee is relatively stronger against a basket of currencies of India’s trading partners compared to its average value over a certain period.
To calculate the percentage difference between the actual value and the base value of 100, we can use the following formula:
Percentage difference = ((actual value – base value) / base value) * 100
For NEER, the percentage difference is:
((105 – 100) / 100) * 100 = 5%
This means that the Indian rupee has appreciated by 5% against a basket of currencies of its trading partners compared to the base value of 100.
Similarly, for REER, the percentage difference is:
((110 – 100) / 100) * 100 = 10%
This means that the Indian rupee is overvalued by 10% compared to the base value of 100.
Now, let’s come to the question of why 100 is used as a benchmark. The base value of 100 is simply a convenient reference point to compare the value of a currency over time.
It is usually chosen as a base value because it is easy to work with, and changes in the value of the currency can be easily expressed as a percentage difference from this base value.
In summary, the number 100 is used as a benchmark in NEER and REER to compare the value of a currency to a basket of currencies of its trading partners. The percentage difference from the base value of 100 is used to express the change in the value of the currency over time.
