Context: Recently, the Reserve Bank of India (RBI) has organized the rupee’s Nominal Effective Exchange Rate (NEER) in relation to the currencies of 36 trading partner countries.
About Currency Exchange Rate

• An exchange rate is the value of one nation's currency versus the currency of another nation or economic zone.
• The currency exchange rate is one of the most important determinants of a country's relative level of economic health.
• Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world.
• A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets.
• A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets.
• A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.

What are the measures to be looked at while considering Rupee exchange rate?

• The Reserve Bank of India tabulates the rupee’s Nominal Effective Exchange Rate (NEER) in relation to the currencies of 36 trading partner countries. This is a weighted index — i.e., countries with which India trades more are given a greater weight in the index.
• A decrease in this index denotes depreciation in rupee’s value; an increase reflects appreciation.
• There is one more measure that is even better at capturing the actual change.
• This is called the Real Effective Exchange Rate (REER).
• It is essentially an improvement over the NEER because it also takes into account the domestic inflation in the various economies.

Impact of Inflation on Exchange Rate

• Many factors affect the exchange rate between any two currencies ranging from the interest rates to political stability (less of either results in a weaker currency). Inflation is one of the most important factors.
• Illustration: Imagine that the Rupee-Dollar exchange rate was exactly 1 in the first year. This means that with Rs 100, one could buy something that was priced at $100 in the US. But suppose 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 (reduce in value) to 1.20.

About Nominal effective exchange rate (NEER)

• It is an unadjusted weighted average rate at which one country’s currency exchanges for a basket of multiple foreign currencies. The nominal exchange rate is the amount of domestic currency needed to purchase foreign currency.
• If a domestic currency increases against a basket of other currencies inside a floating exchange rate regime, NEER is said to appreciate. If the domestic currency falls against the basket, the NEER depreciates.
• It only describes relative value; it cannot definitively show whether a currency is strong or gaining strength in real terms.
• It only describes whether a currency is weak or strong, or weakening or strengthening, compared to foreign currencies.

About Real effective exchange rate (REER) 

• It is the weighted average of a country’s currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country’s currency against each country within the index.
• It is used to measure the value of a specific currency in relation to an average group of major currencies. 
• A country’s REER is an important measure when assessing its trade capabilities because it also takes into account the domestic inflation in the various economies.
• It can also be used to measure the equilibrium value of a country’s currency, identify the underlying factors of a country’s trade flow, and analyze the impact that other factors, such as competition and technological changes, have on a country and ultimately the trade-weighted index.