Mains-GS-3-Economic Development, Prelims- Economy
1. The economic disruption due to the spread of the COVID-19 has adversely affected various aspects of the Indian economy.
2. Other than the growth rates of gross domestic product and gross value added, high-frequency data like sales of automobiles, etc. could also indicate the problems.
3. The exchange rate of the rupee is one such data on the state of the Indian economy’s competitiveness.
What is the currency exchange rate?
1. A currency’s exchange rate vis-a-vis another currency reflects the relative demand among the holders of the two currencies.
2. This demand depends on the relative demand for the goods and services of the two countries.
3. A stronger US dollar than the rupee shows the demand for dollars by those holding rupee is more than the demand for rupees by those holding dollars.
Trade-Weighted Indices
1. Stronger economies have stronger currencies. For instance, as the US economy is relatively stronger than India’s, one US dollar equals to around 76 rupees.
2. The rupee has been losing value (or depreciating/weakening) against the dollar over the past few months.
3. But as India trades with many other countries as well, the economy’s overall competitiveness will be based on rupee’s relation with currencies of all major trade partners.
Which measures are to be looked at?
1. RBI tabulates the rupee’s Nominal Effective Exchange Rate (NEER) in relation to the currencies of 36 trading partner countries. This is a weighted index as greater weight is given to countries with which India trades more.
2. A decrease in this index denotes depreciation in rupee’s value and an increase reflecting appreciation.
3. In NEER terms, the rupee has depreciated to its lowest level since November 2018. The steady loss of rupee’s value shows reduced competitiveness of the Indian economy since July 2019.
4. The recent dip was influenced by the net outflow of foreign portfolio investments from the Indian equity and debt markets.
How does inflation affect exchange rates?
1. Many factors affect the exchange rate between any two currencies ranging from the interest rates to political stability (less of either result in a weaker currency).
2. Inflation is one of the most important factors.
3. If the Indian inflation is 20% and the US inflation is zero, then in the second year, an Indian would need Rs 120 to buy the same item priced at $100, and the rupee’s exchange rate would depreciate to 1.20.
Where does REER stand?
1. Real Effective Exchange Rate (REER) is an improvement over the NEER as it also takes into account the domestic inflation in the various economies.
2. Even in REER terms, the rupee has depreciated and fallen to its lowest level since September 2019.
3. The difference between trends of NEER and REER was due to India’s domestic retail inflation being lower relative to the other 36 countries.
4. As domestic inflation started rising, the REER, too, started depreciating like the NEER.