UPSC Prelims 2022 Q2: NEER and REER of the Rupee — Explained
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?
- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Answer: (c) 1 and 3 only
Statement-wise explanation
- 1: correct — NEER is a weighted average of the rupee's exchange rates against the currencies of India's trading partners. The RBI builds the index so that a rise means the rupee has appreciated, because it counts how many units of foreign currency one rupee buys. So a rising NEER means the rupee is stronger, on average, against the basket (RBI Bulletin, January 2021).
- 2: incorrect — REER is NEER adjusted for the gap between India's prices and its partners' prices. A rise in REER is a real appreciation: Indian goods get dearer than foreign goods once both the exchange rate and inflation are counted. That makes exports less competitive and imports cheaper. So a rising REER signals a loss of trade competitiveness, not an improvement.
- 3: correct — REER = NEER × (domestic prices ÷ weighted foreign prices). If Indian inflation keeps running above partner inflation, the price ratio keeps rising, so REER moves further above NEER over time. RBI data (40-currency basket, 2015-16 = 100) shows this: in 2021-22 NEER was 93.13 while CPI-based REER was 104.83. The rupee had weakened in nominal terms but strengthened in real terms because India's inflation was higher.
How to eliminate
Statement 1 can be settled by definition. An index of the rupee's value going up means the rupee is gaining, so statement 1 is true. That leaves three possible combinations. The trap is statement 2. It sounds positive ('improvement'), but use the export test: a stronger currency in real terms makes Indian goods costlier abroad, so competitiveness falls. If you know only that statement 2 is false, the one option without it is already fixed. Statement 3 follows from the formula: REER is NEER multiplied by a ratio of domestic to foreign prices. If that ratio keeps rising, the two indices must drift apart. The fact to remember: a higher NEER or REER means a stronger rupee, and a higher REER means weaker export competitiveness.
Know more
Effective exchange rates sum up the rupee's movement against many currencies in one number, instead of only against the US dollar.
| Feature | NEER | REER |
|---|---|---|
| What it measures | Weighted average of the rupee's nominal exchange rates against partner currencies | NEER adjusted for relative prices (inflation differential) |
| Inflation adjusted? | No | Yes (RBI uses CPI) |
| Rise means | Nominal appreciation | Real appreciation, so exports lose competitiveness |
| Fall means | Nominal depreciation | Real depreciation, so exports gain competitiveness |
| Main use | Tracking the currency's value | Judging competitiveness and possible over- or under-valuation |
How RBI compiles them
- There are two baskets: a 6-currency index and a broad 40-currency index. In January 2021 the RBI widened the basket from 36 to 40 currencies and moved the base year from 2004-05 to 2015-16 = 100.
- Two weighting schemes are published: trade-weighted and export-weighted. China and the Euro Area carry the largest trade weights.
- REER ≈ NEER × (P_India ÷ P_foreign). In the long run, purchasing power parity says that higher home inflation should be offset by nominal depreciation. If it isn't, REER rises.
Reading the data A REER above 100 suggests the rupee is stronger in real terms than in the base year, which can point to overvaluation. RBI trade-weighted data:
| Year | NEER | REER |
|---|---|---|
| 2015-16 | 99.98 | 99.97 |
| 2021-22 | 93.13 | 104.83 |
| 2024-25 | 91.01 | 105.41 |
| 2025-26 (provisional) | 84.72 | 97.45 |
The gap between the columns comes from India's inflation being higher than its partners'. Note that 'real exchange rate' in NCERT (the price of foreign goods in terms of domestic goods) is defined the other way up: there, a rise means real depreciation. Always check which way an index is built before you read it.
NCERT Concepts to Revise
- Nominal Effective Exchange Rate: Statement 1 turns on what a rise in this trade-weighted index of the rupee means.
- Real Effective Exchange Rate: Statements 2 and 3 depend on how this index adjusts NEER for India's inflation relative to its trading partners.
- Real exchange rate: The NCERT real exchange rate is defined the other way up from REER. Knowing this avoids getting the direction backwards.
- Currency appreciation: You need to know what appreciation means for the rupee to read movements in both indices correctly.
- Dutch disease: Shows what real appreciation does to a country's export competitiveness, the idea behind statement 2.