Rupee's Depreciation: Understanding the 'Real' Fall Beyond Nominal Rates

Answer: D

Statement 1 is correct. NEER is a measure of the weighted average of nominal exchange rates of a currency against a basket of currencies of its trading partners, reflecting the nominal strength. Statement 2 is correct. REER is a more comprehensive measure that adjusts NEER for inflation differentials, reflecting the real purchasing power and trade competitiveness. Statement 3 is correct. A persistent fall in REER indicates a real depreciation of the domestic currency. This means domestic goods become relatively cheaper for foreigners, thereby making exports more competitive and imports more expensive. (Note: The article's summary states 'A falling REER indicates a loss of competitiveness', which is counter-intuitive to standard economic theory where a fall in REER implies a gain in competitiveness. For UPSC, standard economic theory is followed.)

Answer: A

Statement 1 is correct. To prevent the Rupee from depreciating excessively (i.e., to strengthen it), RBI sells foreign currency (e.g., US dollars) from its reserves. This increases the supply of foreign currency and reduces the supply of Rupees in the market, thereby appreciating the Rupee. Statement 2 is correct. India's exchange rate regime is indeed a 'managed float', meaning market forces largely determine the rate, but RBI intervenes to curb excessive volatility or sharp movements. Statement 3 is incorrect. The 'Impossible Trinity' (or Mundell-Fleming Trilemma) states that a country can only choose two out of three policy goals: a fixed exchange rate, free capital mobility, and an independent monetary policy. It cannot achieve all three simultaneously.

Answer: C

Statement 1 is correct. A real depreciation means that for the same amount of foreign currency, more Rupees are needed, making foreign goods and services more expensive in Rupee terms, thus contributing to imported inflation. Statement 2 is correct. A real depreciation makes Indian goods cheaper for foreign buyers, enhancing their price competitiveness in international markets and potentially leading to higher export volumes. Statement 3 is incorrect. The overall impact on CAD is not solely determined by the magnitude of depreciation. It also depends crucially on the price elasticity of demand for exports and imports (Marshall-Lerner condition) and the time lag for these elasticities to manifest (J-curve effect). If demand for imports is inelastic and exports don't respond quickly, CAD might worsen initially. Statement 4 is correct. The J-curve effect describes a phenomenon where a country's trade balance initially deteriorates following a currency depreciation (as import prices rise immediately, while export and import volumes take time to adjust) before eventually improving as export volumes increase and import volumes decrease.