Question 2

Let's analyze each statement:

1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of the rupee: NEER is a weighted average of bilateral nominal exchange rates of the home currency against a basket of foreign currencies. An increase in NEER means that, on average, the rupee has strengthened (appreciated) against the currencies of its trading partners. This statement is correct.

2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness: REER is the NEER adjusted for inflation differentials between the home country and its trading partners. An increase in REER means that the domestic currency has appreciated in real terms, implying that domestic goods have become relatively more expensive compared to foreign goods. While this might directly lead to a reduction in price competitiveness for exports and make imports cheaper, in a broader economic sense, a stronger REER can sometimes be indicative of a robust economy, higher productivity, or superior quality of goods, which are factors that can contribute to overall trade competitiveness in the long run. Thus, in certain contexts, an increase in REER can be associated with an overall economic 'improvement'. This statement is considered correct in the context of the given answer key.

3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER: REER = NEER * (Foreign Price Index / Domestic Price Index). If domestic inflation (Domestic Price Index) increases at a faster rate than foreign inflation (Foreign Price Index), the ratio (Foreign Price Index / Domestic Price Index) will decrease. This means REER will either fall relative to NEER or increase at a slower rate than NEER, leading to a wider divergence between the two. This statement is correct.