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Home / IAS Preparation / NEER And REER

NEER And REER: Definition, Formula, Differences, Importance-UPSC Notes

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NEER and REER are indicators that measure a country's currency value against a basket of foreign currencies, adjusted and unadjusted for inflation respectively.

NEER is an unadjusted weighted average related to the currency exchange of one country for a basket of various types of foreign countries. REER (Real Effective Exchange Rate) is calculated using NEER, and it is higher than NEER.

The complete form of NEER is the Nominal-Effective-Exchange-Rate. The NEER is considered the weighted means of average, which is geometric and related to the bilateral nominal exchange rate of the home currency in terms of other currencies of other countries. There is a significance of NEER, such as this term of economics, that can try to identify the store values of currencies more or less effectively. The other important aspect of the NEER is that it can also define the strength or weakness of a particular country's currency by comparing different countries' currencies. 

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General Studies Paper III

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NEER and REER

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Indian Economy, Economic Development, Resources, Economic Growth, Mobilization, Currency, Global Economies.
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This topic, Neer and Reer UPSC is important from the perspective of the UPSC IAS Examination as it falls under General Studies Paper 3 (Mains) and General Studies Paper 1 (Preliminary), particularly in the Indian Economy Section. In this article, we will discuss REER and NEER in detail. You will learn ways to calculate REER and NEER and their importance, limitations, and differences.

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NEER and REER

The complete form of NEER is the Nominal-Effective-Exchange-Rate. The NEER is considered the weighted means of average, which is geometric and related to the bilateral nominal exchange rate of the home currency in terms of other currencies of other countries. There is a significance of NEER, such as this term of economics, that can try to identify the store values of currencies more or less effectively. The other important aspect of the NEER is that it can also define the strength or weakness of a particular country's currency by comparing different countries' currencies. 

On the contrary, REER is the other essential for the economic condition of a particular country. The meaning of REER in real terms of an effective exchange rate can help measure the value of one country's currency against that of other countries. There is a process to measure REER in that a REER value >100 for the given year indicates that the currency's value has been overvalued. On the other hand, if the REER value is < 100 in a particular year, the currency's value is undervalued. 

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What is the Real Effective Exchange Rate (REER)?

The Real Effective Exchange Rate (REER) is the weighted average of a country's currency against an index or basket of other relevant currencies (REER). The weights are determined by comparing the relative trade balances of each country's currency to those of all the different countries in the index. 

  • An increase in a nation's REER indicates that exports are becoming more expensive while imports are becoming more affordable. 
  • The Real Effective Exchange Rate (REER) compares a nation's currency value to the weighted average of its primary trading partners' currencies.
  • It measures a country's competition with its trading partners on the world stage. 
  • The algorithm weights each trading partner's relative importance to the home country. 
  • If a nation's REER increases, it is shedding its competitive advantage. 
  • After considering domestic inflation, a country's nominal effective exchange rate (NEER) equals its real effective exchange rate (REER).

Check out the article on the Producer Price Index here!

Formula to Calculate REER (REER Formula)

The Real Effective Exchange Rate (REER) is computed using the following formula:

REER = (NEER * CPI Domestic) / (CPI Foreign)

Here:

  • REER stands for Real Effective Exchange Rate.
  • NEER signifies Nominal Effective Exchange Rate.
  • CPI Domestic refers to the Consumer Price Index of the domestic nation.
  • CPI Foreign represents the Consumer Price Index of the foreign country/countries in the currency basket.

The REER divides the NEER by the domestic and foreign Consumer Price Index (CPI) ratio. This adjustment compensates for inflation rates diverging between the domestic country and its trading partners. This approach offers a more precise evaluation of the currency's actual value regarding purchasing power.

Incorporating inflation variations, the REER grants insights into a country's trade competitiveness. It considers nominal exchange rate shifts and relative price levels between domestic and foreign economies.

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UPSC Previous Year Question

 

Q. 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? (PYQ 2022)

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

 

Answer: (c)

What is the Nominal Effective Exchange Rate (NEER)?

The weighted geometric average of the home currency's bilateral nominal exchange rates relative to other currencies is known as the NEER. The nominal effective exchange rate is the domestic money needed to purchase foreign currency (NEER). The NEER measures a country's capacity to compete internationally in the foreign exchange (forex) market. The NEER is also called the trade-weighted currency index among forex dealers.

NEER can be adjusted to account for the inflation rate of the home country relative to the inflation rates of the trading partners of the home country. NEER is not based on each currency's specific links in a nominal exchange rate. Instead, a single, focused statistic—typically an index—shows how the value of one local currency compares to several other currencies at once. Due to changes in macroeconomic and external sector performance brought on by structural changes in the Indian economy, 2015–16 has been chosen as the new base year for the NEER indices. The Nominal Effective Exchange Rate (NEER) of the rupee, about 40 trading partners, and six other currencies are decided by the Reserve Bank of India.

The final number is the Real Effective Exchange Rate (REER). The Nominal Exchange Rate (NEER) defines the quantity of local money required to purchase foreign currency. The trade-weighted currency index, often known as NEER, measures a country's capacity to compete globally in the foreign exchange (forex) market.

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Formula to Calculate NEER (NEER Formula)

The NEER is vital for gauging a nation's global competitiveness in foreign exchange. It considers inflation differences via the Real Effective Exchange Rate (REER). The NEER offers a comprehensive perspective on currency value against multiple others, aiding a broader exchange rate evaluation.

The formula for NEER:

NEER = (w1 * ER1) + (w2 * ER2) + … + (wn * ERn)

Here:

  • NEER stands for Nominal Effective Exchange Rate.
  • w1, w2, …, and we are weighted for each foreign currency in the basket.
  • ER1, ER2, …, ERn are exchange rates of domestic currency with each foreign one.

Weights reflect currency importance in international trade. Exchange rates can be market or official based on data availability and context.

Also, check out Cash Reserve Ratio (CRR) here.

Check out the 'Reer and Neer' video and boost your preparation.

Significance of NEER and REER

The nominal effective exchange rate (NEER) and the real effective exchange rate (REER) are crucial indicators in international economics that assess a country's currency value, trade competitiveness, and overall economic performance. These indicators provide valuable insights into a nation's exchange rate dynamics about its trading partners and real purchasing power.

  • Through comparisons with other countries, this form of competition becomes evident. Employing a specific formula is essential to calculate a country's NEER. Conversely, REER is a method that assesses a nation's average currency value.
  • Weights are determined by comparing the relative trade balance and the country's currency. The real effective exchange rate, or REER, employs a distinct approach to establish this average.
  • In India's context, its NEER is akin to a weighted box. Undoubtedly, the Indian currency holds more weight than the currencies of other nations that engage in significant trade with India.
  • Another critical aspect in India is the REER, which correlates with the country's inflation rate. In 2021, India's Real Effective Exchange Rate reached 116.8, surpassing the previous month's rate. India's REER ranged from 94.8 in 2009 to its peak of 118.3 in 2017.

Read more about the Money Supply here.

Limitations of the Real Effective Exchange Rate (REER)
  • Other than trade and commerce, other factors can affect the REER. The Real Effective Exchange Rate does not account for price fluctuations, tariffs, or other elements that can impact international trade.
  • When costs are greater in one country than in another, trade and commerce may decline, affecting that country's REER. Therefore, any changes in trade must be reflected in the weighting utilized in the REER computation.
  • Additionally, each country's central bank modifies its monetary policy, which can change the home country's interest rates.
  • The REER would be affected, but the impact would be more on the interest rate markets than trade.

Also, read about Strategic Debt Restructuring here for the UPSC Exam!

Limitations of the Nominal Effective Exchange Rate (NEER)
  • These currency indices are helpful for research, analysis, and policy-making but may only partially drive business and investment decisions.
  • These may help policymakers decide whether to intervene in the currency market, but they will remain the same for importers, exporters, and investors interested in one or two currencies.

Check out this article on Panchayat Finance.

Difference Between REER and NEER

The difference between REER and NEER is given in a tabular format for better understanding.

REER

NEER

It stands for Real Effective Exchange Rate.

It stands for Nominal Effective Exchange Rate.

It displays the home currency’s adjusted value in relation to other significant trading currencies.

NEER is unadjusted with respect to inflation.

It eliminates the effects of currency-specific inflation differentials and concentrates solely on exchange rate differentials.

The difference in inflation rates between the country and its trading partners has an influence.

It is determined using the NEER.

It is determined using a currency basket.

As a result of being corrected for inflation, it is thought to be a more accurate estimate.

Due to differences in inflation, it may provide measurements that aren’t exactly precise.

Check out this article on Antidumping and Countervailing Duty.

Conclusion

NEER and REER are the two key components of the economies of various nations that can be used to gauge the state of their economies or their ability to conduct business internationally. The depiction of India indicates that the REER percentage will be four in the fiscal year 2021. The REER determines the cash rate for the specific nation, and in FY 2021, the percentage of cast rate is likewise four.

We hope this article addresses all your doubts regarding REER and NEER. The Testbook provides comprehensive notes for different competitive examinations. It has always assured the quality of its products, such as UPSC Coaching, content pages, live tests, GK and current affairs, mocks, and so on. Ace your UPSC preparation with the Testbook App.

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NEER and REER FAQs

The weighted average of a country's currency in relation to an index or basket of other significant currencies is known as the real effective exchange rate (REER). The relative trade balance of each country's currency is compared to the trade balance of every other country in the index to establish the weights.

REER is higher than NEER because a rise in REER may indicate that imports are becoming less expensive while exports are becoming more exclusive and costly than imports. As a result, it can be said that an increase may signal a decline in trade competitiveness.

The actual exchange rate indicates how much domestic products and services may be exchanged for foreign goods and services, whereas the nominal exchange rate indicates how much foreign currency can be exchanged for a unit of the domestic currency.

An increase in REER suggests a loss in trade competitiveness since it means that exports become more expensive and imports get less expensive.

A weighted average of multiple different foreign currencies is used to calculate NEER, which is a measure of a currency's value. Increases in NEER signify that the local currency has gained value relative to the weighted basket of currencies used by its trading partners.
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