Real & Effective Exchange Rates – Competitiveness Measures
The Nominal Rate ($1 = ₹83) tells you the price. But it doesn't tell you if Indian goods are effectively cheaper or expensive compared to the world. For that, we need REER.
1. The Concept of Effective Exchange Rate (EER)
India trades with USA, Europe, Japan, and China. Looking only at USD/INR is misleading. We need a Weighted Average of Rupee against a "Basket of Currencies" of our trading partners.
A. NEER (Nominal Effective Exchange Rate)
- It is the weighted average of bilateral nominal exchange rates.
- Formula:
Sum (Weight of Country i * Exchange Rate i). - Interpretation: If NEER > 100, Rupee is appreciating against the basket.
B. REER (Real Effective Exchange Rate)
- NEER adjusted for Inflation differentials.
- Why? If Rupee depreciates by 5% but Inflation in India is 10% higher than US, our goods actually became more expensive, not cheaper.
- Formula:
NEER * (Domestic Price / Foreign Price).
2. Why REER Matters? (Competitiveness)
- REER > 100 (Overvalued): Indian goods are expensive. Exports will suffer. Imports will be cheap.
- REER < 100 (Undervalued): Indian goods are cheap. Exports will boom.
- RBI's Goal: Keep REER around 100 (Fair Value) to protect exporters.
3. Comparison: Nominal vs Real
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4. Exam Notes: Writing the Answer
Question: "Distinguish between NEER and REER." (5 Marks)
Answering Strategy:
- Full Form: Nominal Effective vs Real Effective.
- Logic: NEER is just weighted average. REER adds "Inflation Adjustment".
- Use: NEER for financial flows. REER for Trade Competitiveness.
- RBI Basket: Mention RBI tracks 6-currency and 40-currency REER baskets.
Summary
- NEER: A Multilateral Exchange Rate.
- REER: A Multilateral Exchange Rate + Inflation Adjustment.
- Rule: High REER = Bad for Exports. Low REER = Good for Exports.
Quiz Time! 🎯
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