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
2 and 3 only
C
1 and 3 only
Correct answer
D
1, 2 and 3
Explanation
Statements 1 and 3 are correct. The Nominal Effective Exchange Rate is a weighted average of the rupee's exchange rates against the currencies of India's trading partners; in the RBI's index a rise means the rupee has appreciated. The Real Effective Exchange Rate adjusts the NEER for the difference between Indian and foreign inflation, so a rise in REER means Indian goods have become dearer relative to foreign ones. That is a loss of trade competitiveness, not an improvement, so statement 2 is wrong. Because REER is the NEER scaled by the ratio of domestic to foreign prices, inflation in India running faster than in its trading partners pushes REER up relative to NEER and widens the gap between them, as statement 3 says.
Exchange RateNominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER)Indian economyNominal Effective Exchange Rate (NEER)appreciation of rupeeReal Effective Exchange Rate (REER)trade competitivenessdomestic inflationinflation in other countriesdivergence