1. An increase in the Nominal Effective Exchange Rate (NEER) indicates the appreciation of the 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 is correct? 

(a) 1 and 2 only 

(b) 2 and 3 only 

(c) 1 and 3 only 

(d) 1, 2 and 3 

Ans: c

Explanation:

Nominal exchange rate:

The exchange rate is the price of one currency expressed in terms of another currency.  Two conventions are used:

E: Price of home currency in terms of foreign currency 

R: Price of foreign currency in terms of home currency

                                                                               E = 1 / R

Domestic currency =  Indian Rupee

Foreign currency =     $USD

Let us consider price of home currency in terms of foreign currency (E):

80 Rs.    =     1$

1  Rs.     =     1/80 $

 1 Rs.        =    0.0125$   is the nominal exchange rate

In case of appreciation of Rupee say for example,

72 Rs.      =     1$

1  Rs.     =        1/72 $

 1 Rs.      =      0.0138 $,   so the nominal exchange rate increased. 

Therefore the increase in nominal exchange rate leads to appreciation of rupee (IMF concept).

Nominal effective exchange rate:

NEER is the weighted average of nominal exchange rates where weights used are shares of trading partners in the foreign trade of a country.

For example, In foreign trade of India US share is 40%, UK share is 35%, and UAE share is 25%

Then 

NEER  =     (0.0125*40  + 0.01*35  +    0.025*25) /  100

            =       (0.5  + 0.35  +  0.625)/ 100

            =       0.01475

Like NER, increase in NEER also indicates an appreciation of the local currency against the weighted basket of currencies of its trading partners.

NER considers exchange rate between two countries, whereas NEER considers exchange rate between a country and its trading partners.

Hence statement 1 is correct 

What is the real exchange rate?

The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a Rupee, for example) and the ratio of prices between the two countries.

 The core equation is RER = EP*/P, 

where, in our example, E is the nominal dollar/Rupee  exchange rate, P* is the average price of a good in India , and P is the average price of the good in the United States.

Example, E = 0.0125 and for an article, 

If the Indian price is 160 rupees  and the U.S. price is $ 1

 Then   RER = (0.0125) X (160 ) ÷ 1  

which yields an Real Exchange Rate of 2.

But if the Indian price were 200 rupees and the U.S. price $1, 

then RER   =   ( 0.0125) X 200 ÷ 1, 

which yields an Real Exchange Rate of 2.5.

Increase of RER indicates higher prices for the producers and less competitive.

Concept of Competitveness

Tradable goods can be produced domestically and then be sold either domestically or abroad in exchange for other goods. Competitiveness is the incentive for domestic/foreign economies to produce and/or purchase these goods in/from the domestic economy, rather than in/from foreign economies. At the level of individual producers, competitiveness is generally defined on the basis of (quality adjusted) prices: lower-price producers are more competitive.

Real Effective Exchange Rate:

REER is the real effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.

An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an increase indicates a loss in trade competitiveness.         

Hence statement 2 is incorrect.

If inflation in domestic country is high, more rupees have to be spent to purchase basket of goods when compared to the international level, this will lead to increase in REER. Since NEER remains nearly stable, increase in REER leads to increasing divergence between NEER and REER.

Hence statement 3 is correct.

Read: Solved Economy PYQs With Explanation 2022 UPSC Prelims