Nominal Effective Exchange Rate (NEER) tells about a country’s international competitiveness in terms of the foreign exchange (forex) market, it is also known as the trade-weighted currency index. The real effective exchange rate (REER) is the nominal effective exchange rate (NEER) adjusted by relative prices or costs and is captured in inflation differentials between the home economy and trading partners. This article discusses the differences between trade weighted indexes of REER and NEER.

What are REER and NEER?

• The real effective exchange rate (REER) is the weighted average of a country’s currency as compared to an index or basket of other major currencies.
• A comparison of the relative trade balance of a country’s currency against each country within the index tells about the weightage.
• This exchange rate is used to determine an individual country’s currency value relative to the other major currencies in the index.
• The nominal effective exchange rate (NEER) is the unadjusted weighted average rate at which one country's currency is exchanged for a basket of foreign currencies.
• The nominal exchange rate determines how much domestic money is required to purchase foreign currency.
• NEER tells about a country’s international competitiveness in terms of the foreign exchange (forex) market, it is also known as the trade-weighted currency index.

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REER and NEER - Overview

• Due to India’s changing foreign trade pattern, the coverage of NEER/REER indices for the new base year, i.e., 2015-16, has been expanded from 36 to 40 currencies.
• As a result of the evolution of bilateral trade shares of major trading partners, there has been the inclusion of eight new countries in the 40-currency basket that are Angola, Chile, Ghana, Iraq, Nepal, Oman, Tanzania, and Ukraine.
• Countries replaced in the earlier 36-currency basket are Argentina, Pakistan, the Philippines, and Sweden.
• New entrants to the list accounted for 5.4 percent of India’s total merchandise trade vis-à-vis 1.4 percent by the exiting countries.
• Therefore, the new NEER/REER basket represents 88 percent of India’s total trade as compared with 84 percent in the case of the 36-currency basket.

Difference Between REER and NEER

Conclusion

Given the fact that the global trade environment is undergoing a shift, it is important that the NEER/REER basket of the rupee is reviewed regularly. Going forward, large capital inflows unless fully absorbed through current account deficit and/or mopped up as foreign exchange reserves can cause an appreciation of the rupee and potentially undermine the export competitiveness, focus on price stability under the FIT regime should remain a policy priority to offset the erosion in external competitiveness which may emanate from the appreciation of the rupee in nominal terms.

FAQs

MCQs

1. What does NEER stand for?

A) Nominal Effective Exchange Rate
B) National Economic Evaluation Rate
C) Neutral Exchange Evaluation Rate
D) Non-Equity Effective Rate

2. Which of the following correctly defines REER?

A) A measure of inflation in a country
B) A nominal exchange rate index
C) NEER adjusted for inflation differences
D) A measure of foreign exchange reserves

3. Which of the following factors is included in calculating REER but not NEER?

A) Currency value
B) Inflation rates
C) Interest rates
D) Government policies

4. A rise in REER suggests:

A) A depreciation of the domestic currency
B) No change in the competitiveness of the currency
C) An appreciation of the domestic currency
D) Increased inflation in the domestic market

5. Which index is more comprehensive in assessing a country’s international competitiveness?

A) NEER
B) REER
C) Exchange Rate Index
D) Trade Index

GS Mains Questions and Answers

Q1: Compare NEER and REER, and discuss their significance in the context of India's trade and economic policies.

Answer: NEER (Nominal Effective Exchange Rate) and REER (Real Effective Exchange Rate) are two important indices used to assess a country's currency performance relative to its trading partners. NEER measures the value of a country's currency against a basket of foreign currencies, weighted by the significance of trade with each partner, without adjusting for inflation. In contrast, REER adjusts NEER for inflation differentials between the home country and its trading partners.

NEER is useful for tracking the nominal movement of exchange rates but does not provide a complete picture of international competitiveness, as it ignores price level differences. REER, by incorporating inflation, offers a more accurate assessment of the purchasing power of a currency and its impact on trade. In the context of India, a rising REER could indicate a loss of trade competitiveness, as exports become more expensive in foreign markets. Policymakers monitor REER to gauge the need for adjustments in monetary policy to maintain export competitiveness and manage inflationary pressures. Both indices play a crucial role in shaping India's trade and exchange rate policies.

Q2: How does a change in REER affect India's export competitiveness? Discuss with examples.

Answer: A change in REER has a direct impact on India's export competitiveness. When REER rises, it indicates an appreciation of the Indian rupee in real terms, meaning that Indian goods and services become more expensive in international markets. This can lead to a reduction in export volumes, as foreign buyers may seek cheaper alternatives. For example, during periods of strong rupee appreciation, Indian textile exports have faced stiff competition from countries with lower REER values, such as Bangladesh and Vietnam.

Conversely, a fall in REER implies a depreciation of the rupee in real terms, making Indian goods cheaper for foreign buyers. This can boost export competitiveness, leading to increased demand for Indian products in global markets. Therefore, managing REER is critical for maintaining the balance of trade and ensuring that Indian exports remain competitive in an increasingly globalized market.

Q3: Analyze the role of NEER and REER in determining India's monetary and fiscal policy decisions.

Answer: NEER and REER play a crucial role in influencing India's monetary and fiscal policy decisions. NEER helps policymakers understand the nominal movement of the rupee against a basket of currencies, providing insights into foreign exchange market trends. However, REER is more significant for policy decisions, as it reflects both exchange rate movements and inflation differentials, offering a comprehensive view of currency competitiveness.

A rising REER may signal an overvaluation of the rupee, leading to a reduction in export competitiveness and an increase in imports, potentially widening the trade deficit. In such cases, the Reserve Bank of India (RBI) may adjust monetary policy, such as lowering interest rates or intervening in the forex market, to control inflation and bring the rupee back to a competitive level. On the fiscal side, the government may implement export incentives or reduce tariffs to boost competitiveness. Thus, NEER and REER are integral to shaping India's macroeconomic strategies and maintaining external balance.

Previous Year Questions on REER and NEER

1. UPSC CSE Prelims 2019:

Question: Which of the following best describes REER?

A) An index adjusting the nominal exchange rate for inflation differences
B) A measure of a country's foreign exchange reserves
C) A policy tool used to control inflation
D) A measure of trade balance between countries

Answer: A

Explanation: REER (Real Effective Exchange Rate) adjusts the nominal exchange rate (NEER) by considering inflation differences between the domestic economy and its trading partners.

2. UPSC CSE Mains 2020 (GS Paper 3):

Question: "A rising REER suggests an appreciation of the currency and can affect the trade competitiveness of a country." Discuss the implications of REER for India's trade policies and economic growth.

Answer: A rising REER indicates that the domestic currency has appreciated in real terms, making exports more expensive and imports cheaper. This can negatively impact the competitiveness of Indian goods in global markets, leading to a decline in export revenues. For a developing country like India, which relies on exports for economic growth, a high REER could widen the trade deficit and slow down industrial growth.

To address this, India's trade policies may need to focus on providing export incentives, improving product quality, and diversifying markets. Additionally, managing inflation and maintaining a balanced exchange rate are crucial to ensuring that India's exports remain competitive. In the long term, economic policies that foster innovation and productivity can help mitigate the adverse effects of a rising REER on trade and growth.