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Q92 (IAS/2022) Economy › External Sector & Trade › Exchange rate dynamics Official Key

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 ?

Result
Your answer: —  ·  Correct: C
Explanation

The correct answer is Option 3 (1 and 3 only). Below is the comprehensive explanation:

  • Statement 1 is correct: The Nominal Effective Exchange Rate (NEER) is a weighted average of bilateral exchange rates of the rupee against a basket of currencies. An increase in the NEER index indicates that the rupee is gaining value against the basket, signifying appreciation.
  • Statement 2 is incorrect: The Real Effective Exchange Rate (REER) is the NEER adjusted for inflation differentials. An increase in REER implies that domestic goods have become more expensive relative to foreign goods, leading to a loss of trade competitiveness, not an improvement.
  • Statement 3 is correct: REER is calculated as [NEER × (Domestic Price Index / Foreign Price Index)]. If domestic inflation rises significantly faster than foreign inflation, the price ratio increases, causing the REER to rise even if the NEER remains stable. This creates an increasing divergence between the two indices.

Therefore, while NEER tracks currency value (1), and inflation creates a gap between nominal and real rates (3), an increasing REER actually hurts exports, making statement 2 false.

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Q. With reference to the Indian economy, consider the following statements : 1. An increase in Nominal Effective Exchange Rate (NEER) indic…
At a glance
Origin: From standard books Fairness: High fairness Books / CA: 10/10 · 0/10
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This is a pure static concept question found in every standard economy manual (Vivek Singh, Singhania, NCERT). It tests the inverse relationship between 'Currency Strength' and 'Export Competitiveness'. If you understood the formula REER = NEER × (Domestic Prices / Foreign Prices), this was a free hit.

How this question is built

This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.

Statement 1
In the context of the Indian economy, does an increase in the Nominal Effective Exchange Rate (NEER) indicate a nominal appreciation of the Indian rupee?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 26
Presence: 5/5
“So, when a currency appreciates (either in real or nominal terms) then it means that its trade is becoming less competitive.• In the case of NER, if the exchange rate is $.014/Rupee and if its value is increasing to $.028/Rupee that means we are getting more dollars per rupee and hence we say that rupee is appreciating and this means that rupee trade is becoming less competitive.• In the same way, if the value of ½ (abroad w.r.t. domestic) in case of real exchange rate is increasing that means rupee is appreciating and since rupee is appreciating, so Indian trade is becoming less competitive or US trade is becoming more competitive.• Now if we want to create an index of real exchange rate and represent the value ½ with 100, then if ½ is increasing (Refer the figure below) that means the real index number 100 will increase, and we will say that rupee is appreciating (in real terms) and rupee (Indian) trade is becoming less competitive.• And if ½ is decreasing then the number 100 will decrease (Refer the figure below) which will mean that rupee is depreciating in real terms and hence (Indian) exports will become more competitive.”
Why this source?
  • Gives a direct numerical example: a rise in the nominal exchange rate expressed as foreign per rupee means more foreign currency per rupee and is described as rupee appreciation.
  • Explicitly links an increase in nominal exchange measures to the rupee 'appreciating' and notes competitiveness implications.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 27
Presence: 4/5
“• If India wants to measure its export competitiveness with respect to its trading partners with just one parameter, then it calculates Real Effective Exchange Rate (REER) which is a weighted average (with respect to trade value) of the Real Exchange Rates of its trading partners. Similarly, if India wants to calculate its nominal exchange rate with respect to a group of other countries, then it can calculate Nominal Effective Exchange Rate (NEER).• When Real Exchange Rate = 1, Nominal Exchange Rate = PPP Exchange rate, and we say that the currencies are at purchasing power parity.”
Why this source?
  • Defines NEER as the nominal exchange rate with respect to a group of countries (a weighted average).
  • By defining NEER as a nominal index, an increase in NEER corresponds to a nominal strengthening of the domestic currency against the basket.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > HISTORY OF EXCHANGE RATE SYSTEM IN INDIA > p. 496
Presence: 4/5
“• 1947-71: As India was one of the founding members of IMF, India was obligated to follow Bretton Woods system of adjustable peg system of exchange rate. The exchange rate was pegged in terms of US Dollar, which was assigned gold value at a fixed price. India was required to maintain its market exchange rate within ±1 per cent of the defined value. The system followed was also called the Par Value System. Nominal Effective Exchange Rate (NEER) - It is a measure of the value of a currency against a weighted average of a basket of foreign currencies. The currencies are weighted according to the amount of trade with that country.”
Why this source?
  • States NEER measures the value of a currency against a weighted basket of foreign currencies.
  • Supports interpretation that movements in NEER reflect changes in the currency's nominal value versus trading partners.
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