🧷 Authentic Classroom Explanation by IAS Monk

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📌 The Question:

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
(d) 1, 2 and 3

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✅ Correct Answer: (c) 1 and 3 only

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🧠 Classroom Explanation

• Statement 1 is correct
  • NEER (Nominal Effective Exchange Rate) measures the value of a currency against a weighted basket of foreign currencies without adjusting for inflation.
  • An increase in NEER signifies that the domestic currency (rupee) has appreciated against its trading partners’ currencies.
• Statement 2 is NOT correct
  • REER (Real Effective Exchange Rate) adjusts NEER for relative inflation differentials.
  • An increase in REER makes exports more expensive and imports cheaper, leading to a loss of trade competitiveness, not an improvement.
• Statement 3 is correct
  • REER reflects both exchange rate movement and inflation differential.
  • When domestic inflation rises faster than inflation in trading partner countries, REER increases even if NEER remains stable or declines.
  • This leads to a divergence between NEER and REER, a pattern clearly observed in India during periods of elevated domestic inflation.

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🔍 Curiosity Raiser

Why can a country’s currency appear stable in forex markets but still lose export competitiveness?

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🧘 IAS Monk Whisper

Exchange rates speak in prices,
but competitiveness listens to inflation.