UPSC Prelims 2022 Q2: Indian Economy – External Sector & Balance Of Payments
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
Answer: (c) 1 and 3 only
Explanation
NEER and REER — measuring the rupee
| Index | What it measures |
|---|---|
| NEER (Nominal Effective Exchange Rate) | Rupee's value against a basket of currencies, weighted by trade |
| REER (Real Effective Exchange Rate) | NEER adjusted for inflation differences between India and its partners |
Checking the statements:
| Statement | Verdict | Reason |
|---|---|---|
| 1. Rise in NEER = rupee appreciation | Correct | A higher index means the rupee buys more foreign currency |
| 2. Rise in REER = better trade competitiveness | Wrong | A rising REER means Indian goods are getting costlier abroad — competitiveness falls |
| 3. Higher domestic inflation widens the NEER–REER gap | Correct | REER includes relative prices, so higher Indian inflation pushes REER away from NEER |
Answer: (c) 1 and 3 only.
Why each option is right or wrong
- (a) Incorrect. Statement 2 is false; a rising REER means lower competitiveness.
- (b) Incorrect. Statement 2 is false, and it leaves out the true Statement 1.
- (c) CORRECT. A rising NEER means appreciation, and higher Indian inflation widens the NEER–REER gap.
- (d) Incorrect. Statement 2 is false, so 'all three' fails.
Key point
NEER up = rupee stronger. REER up = exports costlier (less competitive). Inflation gap = NEER–REER divergence.
Remember
A rising REER means falling trade competitiveness.
Common mistakes
- Thinking a higher REER helps exports; it actually makes them more expensive.
- Forgetting that the RBI's index is set so that a rise means appreciation.
- Confusing REER with the simple rupee–dollar rate.
Exam tip
Real = nominal + inflation. If Indian prices rise faster than partners', REER climbs above NEER.
Sources
- RBI — Indices of NEER and REER of the Indian Rupee
- NCERT Class XII — Introductory Macroeconomics, Ch 6 (Open Economy Macroeconomics)