NEER and REER in Indian Economy UPSC Prelims PYQ 2022

With reference to the Indian economy, consider the following statements:

An increase in the Nominal Effective Exchange Rate (NEER) indicates the appreciation of the rupee.
An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.

RBI has developed Nominal Effective Exchange Rate (NEER) indices for the rupee against two baskets of currencies.
One basket has six currencies: US dollar, euro, Chinese yuan, British pound, Japanese yen, and Hong Kong dollar.
The other NEER index covers a larger basket of 40 currencies, representing countries contributing to about 88% of India’s annual trade.
NEER indices are calculated based on a reference base year value of 100 for 2015-16.
Increases in NEER values indicate the rupee’s effective appreciation against these currencies, while decreases suggest overall exchange rate depreciation

While the Nominal Effective Exchange Rate (NEER) reflects movements in the rupee’s external value against a basket of currencies, it doesn’t consider inflation, which affects the rupee’s internal value.
REER adjusts the NEER for inflation differentials between the home country and its trading partners.
An increase in REER implies that the costs of products exported from India are rising more than the prices of imports into the country. This results in a loss of trade competitiveness, which may not be favourable in the long term.

If domestic inflation increases faster than inflation in other countries, the REER will increase even if the NEER remains constant. This will lead to a divergence between NEER and REER.

Effective Exchange Rate (EER): The rupee’s strength or weakness depends on its exchange rate with the US dollar and other global currencies. This includes a basket of currencies of India’s major trading partners, known as the rupee’s effective exchange rate (EER).
The Effective Exchange Rate (EER) is measured using an index similar to the Consumer Price Index (CPI). The CPI measures the average retail price of a standard consumer basket of goods and services over a specific period relative to a fixed base period. Similarly, the EER measures the weighted average of the rupee’s exchange rates against the currencies of India’s major trading partners.
Currency weights in the EER are determined by each country’s share in India’s total foreign trade.
There are two measures of the Effective Exchange Rate (EER).
1. Nominal EER or NEER.
2. Real Effective Exchange Rate (REER).