NEER Vs REER:

In a situation where there are multiple trade partners, the effect of cross-currency movements are judged by nominal effective exchange rate (NEER) and real effective exchange rate (REER). The construction of export weighted NEER index is shown in the Table.

We make the following assumptions:

i) India's trading partners are the UK and the US

ii) Share of the US in India's trade = 70%

iii) Share of the UK in India's trade = 30%

The NEER index is the trade weighted average of the trade flows between India and the UK, and between India and the US. For example, for period 2 the NEER index is 100 × 0.3 + 90 × 0.7 = 93. With unchanging trade shares, when rupee-dollar nominal exchange rate falls by 10%, NEER falls by 7%(that is, 70% of 10%). When the Rupee- pound nominal exchange rate increases by 20%, then NEER increases by 6% (that is, 30% of 20%). Thus, the exchange rates of the major trading partners influence the movements of NEER.

When NEER is adjusted for the differences in relative prices between trading partners, the trade weighted REER is obtained. Table 18.3 presents the comparative NEER and REER indices of India for the period 1991-2003. We find that rupee has been strengthening against the currencies of major trading partners. A comparison with the REER shows that the except for 1996-97 and 2003-04, the percentage increase in domestic prices has been more than that in the major trading partners. However, this has been neutralized, to some extent, by the rupee depreciation against the dollar.