With reference to the Indian economy, consider the following statements:

1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.

2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.

3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.

Which of the above statements are correct ?

The correct answer is 1 and 3 only.

Step-by-Step Explanation:

1. Understanding Nominal Effective Exchange Rate (NEER):
NEER is a weighted average of bilateral exchange rates of the home currency (the Indian Rupee) against a basket of currencies of its major trading partners, without adjusting for inflation. An increase in the NEER value indicates that the domestic currency (Rupee) is appreciating against the basket of foreign currencies. Conversely, a decrease in NEER indicates depreciation. Therefore, Statement 1 is correct.

2. Understanding Real Effective Exchange Rate (REER):
REER is the weighted average of a country's currency in relation to an index or basket of other major currencies, adjusted for the effects of inflation. It is calculated as:
REER = NEER × (Domestic Price Index / Foreign Price Index)
An increase in a country's REER implies that its exports become more expensive and imports become cheaper. Consequently, an increase in REER indicates a loss or decline in trade competitiveness, not an improvement. Therefore, Statement 2 is incorrect.

3. Divergence between NEER and REER due to Inflation:
As seen from the relationship between REER and NEER, the divergence between the two rates is driven by the inflation differential between the domestic country and its trading partners (Domestic Price Index / Foreign Price Index). If domestic inflation in India is consistently higher than inflation in other partner countries, the ratio of domestic prices to foreign prices will rise. This rising inflation differential causes the REER to diverge upward relative to the NEER. Hence, an increasing trend in relative domestic inflation is likely to cause an increasing divergence between NEER and REER. Therefore, Statement 3 is correct.

Since Statements 1 and 3 are correct and Statement 2 is incorrect, the correct option is 1 and 3 only.