Understanding NEER and REER in the Simplest Way
Imagine you are traveling and exchanging money. You want to know how strong your currency is compared to other countries. This is where NEER and REER come in!
1. Nominal Effective Exchange Rate (NEER) – "How Strong is My Currency?"
What is NEER?
NEER tells us how much a country's currency is worth compared to multiple foreign currencies.
Example:
Let’s say India trades mainly with the US and China, and:
- $1 = ₹80 (US Dollar)
- 1 Chinese Yuan = ₹10
- India trades 60% with the US and 40% with China.
Now, NEER is the average exchange rate based on trade importance.
- If the rupee strengthens (e.g., $1 = ₹75), NEER increases → Rupee is stronger.
- If the rupee weakens (e.g., $1 = ₹85), NEER decreases → Rupee is weaker.
Key Point:
- A higher NEER = Rupee is stronger, but exports become more expensive.
- A lower NEER = Rupee is weaker, but exports become cheaper.
2. Real Effective Exchange Rate (REER) – "Is My Trade Competitive?"
What is REER?
REER adjusts NEER for inflation differences between countries to measure trade competitiveness.
Example:
Suppose an iPhone costs:
- ₹1,00,000 in India
- $1,000 in the US
If inflation in India is high, the price of an iPhone might rise to ₹1,10,000, while in the US, it stays at $1,000.
Now, even if the exchange rate ($1 = ₹80) stays the same, Indians have to pay more rupees for the same iPhone! This means Indian goods are becoming expensive compared to foreign goods, reducing India's export competitiveness.
Key Point:
- If REER increases, Indian goods become expensive → Exports fall.
- If REER decreases, Indian goods become cheaper → Exports rise.
Key Differences: NEER vs. REER
| Feature |
NEER (Nominal Exchange Rate) |
REER (Real Exchange Rate) |
| What it measures? |
Strength of a currency compared to many foreign currencies. |
Trade competitiveness after adjusting for inflation. |
| Does it consider inflation? |
❌ No |
✅ Yes |
| If it increases? |
Rupee is stronger, but exports become expensive. |
Rupee is stronger, exports become expensive, and India loses trade competitiveness. |
| If it decreases? |
Rupee is weaker, but exports become cheaper. |
Rupee is weaker, exports become cheaper, and India gains trade competitiveness. |
Final Takeaway:
- NEER shows how strong a currency is globally.
- REER shows if a country's trade is competitive by adjusting for inflation.
- A higher REER makes exports costly, while a lower REER makes exports cheaper.
The graph above illustrates how NEER (blue line) and REER (red line) diverge over time due to inflation.
- NEER increases gradually because it does not consider inflation.
- REER increases faster as domestic inflation rises compared to other countries.
- The growing gap between NEER and REER represents the divergence caused by inflation differences.
Divergence means the two values (NEER and REER) are moving apart from each other over time.
Why Does This Happen?
- NEER considers only the exchange rate, so it changes gradually.
- REER includes both the exchange rate and inflation. If inflation in India is higher than in other countries, REER increases faster than NEER.
- This causes a gap between NEER and REER, meaning they are diverging (moving away from each other).
So, the bigger the inflation difference between India and its trading partners, the larger the divergence between NEER and REER!
Example for Better Understanding
Let’s say:
- NEER = 100 (fixed for simplicity)
- Initial REER = 100
- Inflation in India is 10% but in other countries, it is 2%
Because of inflation, Indian goods are now 8% costlier (10% - 2%), so REER increases to 108, while NEER is still 100.
Conclusion:
- When inflation in India is higher than in other countries, REER increases faster than NEER.
- This causes a growing gap (divergence) between NEER and REER.
