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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

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.
Statement 2
In the context of the Indian economy, does an increase in the Real Effective Exchange Rate (REER) indicate an improvement in India's trade competitiveness?
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. 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 REER as a weighted average of real exchange rates used specifically to measure export competitiveness.
  • Links REER directly to the assessment of a country's trade competitiveness, so movements in REER are relevant to competitiveness.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 26
Presence: 5/5
“And this is also called 'Real Exchange Rate' (RER) i.e., RER = NER/PPP (US w.r.t. India) • Trade competitiveness of US w.r.t. India is ½ (<1), this means that US products are less competitive as compared to India which also means that "in any amount of money, whatever we can purchase from India, we will be able to purchase only half of the items from US".• If this ½ will start increasing, this means that US trade competitiveness is increasing (but may be less than India) and once it reaches to 1 then it means that both the countries trade is equally competitive i.e. in any amount of money we will be able to purchase the same (quantity of) products from India and US and trade may stop.• If trade competitiveness of US w.r.t.”
Why this source?
  • Explains interpretation of real exchange rate movements: an increase in a country's RER implies that country's trade competitiveness is increasing.
  • Gives the RER = 1 (PPP) benchmark and describes rising RER as movement toward greater competitiveness.
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
“NEER is not adjusted for inflation. Real Effective Exchange Rate (REER) - It is NEER adjusted with inflation index.”
Why this source?
  • Clarifies that REER is NEER adjusted for inflation, so REER captures real (price-adjusted) competitiveness rather than nominal movements.
  • Implied that REER changes reflect competitiveness after accounting for relative inflation effects.
Statement 3
In the context of the Indian economy, does a rising trend in domestic inflation relative to inflation in other countries cause REER to diverge increasingly from NEER?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
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: 5/5
“NEER is not adjusted for inflation. Real Effective Exchange Rate (REER) - It is NEER adjusted with inflation index.”
Why this source?
  • Explicitly defines REER as NEER adjusted with an inflation index.
  • If REER equals NEER adjusted for inflation, differential inflation will change REER but not NEER.
  • Therefore a rising domestic inflation relative to other countries will alter REER relative to NEER, causing divergence.
Pattern takeaway: UPSC loves testing the 'Counter-Intuitive' aspects of Economics. A 'Strong' Rupee sounds good but is bad for exports. They test if you can distinguish between Nominal movements (Market sentiment) and Real movements (Inflation adjusted).
How you should have studied
  1. [THE VERDICT]: Sitter. Source: Chapter on External Sector/Exchange Rates in Vivek Singh or Nitin Singhania.
  2. [THE CONCEPTUAL TRIGGER]: External Sector > Exchange Rate Management > Indices (NEER/REER).
  3. [THE HORIZONTAL EXPANSION]: Memorize: REER ↑ = Appreciation = Competitiveness ↓. REER ↓ = Depreciation = Competitiveness ↑. Sibling concepts: J-Curve Effect, Impossible Trinity, RBI's 40-currency vs 6-currency basket, Purchasing Power Parity (PPP).
  4. [THE STRATEGIC METACOGNITION]: Do not rely on 'English' intuition where 'Increase' and 'Improvement' sound positive together. In Economics, a 'Strong' currency (Appreciation) is 'Bad' for exporters. Always write the equation: REER ≈ NEER + (Inflation Differential).
Concept hooks from this question
📌 Adjacent topic to master
S1
👉 Nominal Effective Exchange Rate (NEER) — definition and role
💡 The insight

NEER is the weighted nominal exchange-rate index of the domestic currency against a basket of foreign currencies, so its movement reflects nominal value changes of the rupee.

High-yield for macroeconomics and international trade questions: understanding NEER helps answer questions on currency valuation, exchange-rate policy, and multilateral competitiveness. It links to topics on trade baskets, exchange-rate regimes, and balance of payments.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 27
  • 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
🔗 Anchor: "In the context of the Indian economy, does an increase in the Nominal Effective ..."
📌 Adjacent topic to master
S1
👉 Interpreting nominal exchange-rate movements as appreciation or depreciation
💡 The insight

A rise in a nominal exchange-rate measure expressed as foreign currency per rupee means more foreign currency per rupee and is interpreted as rupee appreciation.

Essential for answering questions on effects of exchange-rate changes on exports/imports and policy responses. Enables quick classification of scenarios (appreciation vs depreciation) and connects to exchange-rate regime discussions.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 26
  • Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 17: India’s Foreign Exchange and Foreign Trade > WHICH EXCHANGE RATE SYSTEM SUITS AN ECONOMY BEST? > p. 495
🔗 Anchor: "In the context of the Indian economy, does an increase in the Nominal Effective ..."
📌 Adjacent topic to master
S1
👉 Real Effective Exchange Rate (REER) and competitiveness
💡 The insight

REER adjusts nominal exchange movements for relative prices; real appreciation reduces export competitiveness even if the nominal currency is stronger.

Crucial for questions distinguishing nominal valuation from real competitiveness effects, linking inflation differentials, trade performance, and policy implications such as export competitiveness and macro stability.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 26
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 27
🔗 Anchor: "In the context of the Indian economy, does an increase in the Nominal Effective ..."
📌 Adjacent topic to master
S2
👉 REER as a weighted aggregate of bilateral real exchange rates
💡 The insight

REER combines bilateral real exchange rates into a single measure used to assess export competitiveness.

High-yield concept for questions on competitiveness and international trade policy; connects exchange rate measurement to trade outcomes and enables evaluation of aggregate competitiveness effects across trading partners.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 27
🔗 Anchor: "In the context of the Indian economy, does an increase in the Real Effective Exc..."
📌 Adjacent topic to master
S2
👉 Interpreting Real Exchange Rate movements
💡 The insight

A rising real exchange rate for a country is interpreted as an increase in that country's trade competitiveness (with RER = 1 as PPP parity).

Crucial for answering items on whether appreciation/depreciation or RER changes help or harm exports; links to PPP, export performance, and balance of payments analysis.

📚 Reading List :
  • Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 1: Fundamentals of Macro Economy > 3. Real Exchange Rate (RER) > p. 26
🔗 Anchor: "In the context of the Indian economy, does an increase in the Real Effective Exc..."
📌 Adjacent topic to master
S2
👉 NEER vs REER — the role of inflation adjustment
💡 The insight

REER adjusts the nominal effective rate for relative price levels, so it reflects real competitiveness after inflation differences are considered.

Important for distinguishing nominal and real exchange rate effects in policy questions; helps explain divergence between nominal currency moves and real competitiveness outcomes.

📚 Reading List :
  • 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
🔗 Anchor: "In the context of the Indian economy, does an increase in the Real Effective Exc..."
📌 Adjacent topic to master
S3
👉 NEER versus REER
💡 The insight

REER is defined as NEER adjusted for inflation, so understanding the distinction explains how inflation differentials affect real exchange rates.

High-yield for macro and external sector questions: it links nominal exchange movements to real competitiveness and trade outcomes. Mastery helps answer questions on competitiveness, currency valuation, and policy responses.

📚 Reading List :
  • 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
🔗 Anchor: "In the context of the Indian economy, does a rising trend in domestic inflation ..."
🌑 The Hidden Trap

The RBI REER Baskets. RBI calculates REER using 6-currency and 40-currency baskets. The 6-currency basket includes US Dollar, Euro, Chinese Renminbi, Pound Sterling, Japanese Yen, and Hong Kong Dollar. Prediction: UPSC will ask which currencies are in the 6-currency basket or about the trade-weighting methodology.

⚡ Elimination Cheat Code

The 'Trader's Logic': If your currency gets 'stronger' (Appreciates/Increases), your goods become expensive for foreigners. Expensive goods = Harder to sell = Worse competitiveness. Statement 2 claims 'Improvement', which contradicts this logic. Eliminate Stmt 2 → Options A, B, and D are gone. Answer is C.

🔗 Mains Connection

Mains GS3 (Export-Led Growth): High inflation (Stmt 3) leads to Real Appreciation (REER ↑) even if the Nominal Exchange Rate is stable. This explains why India struggles with export competitiveness despite a seemingly cheap Rupee—structural inflation eats away the price advantage.

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