REAL VALUE OF RUPEE

The real value of the rupee reflects its true purchasing power, adjusting for inflation and changes in price levels both domestically and internationally. Unlike the nominal exchange rate, which is simply the market rate at which one currency can be exchanged for another, the real value considers how much goods and services a currency can buy.

Understanding Real Value vs. Nominal Value

• Nominal Exchange Rate: This is the rate at which one currency can be exchanged for another. For example, if 1 USD = 83 INR, this is the nominal exchange rate.
• Real Exchange Rate: This adjusts the nominal exchange rate by accounting for differences in price levels (inflation) between countries. It reflects the true purchasing power of the rupee relative to other currencies.

Real Exchange Rate=Nominal Exchange Rate×Price Level in IndiaPrice Level in the Foreign Country\text{Real Exchange Rate} = \text{Nominal Exchange Rate} \times \frac{\text{Price Level in India}}{\text{Price Level in the Foreign Country}}Real Exchange Rate=Nominal Exchange Rate×Price Level in the Foreign CountryPrice Level in India​

Key Factors Affecting the Real Value of the Rupee

1. Inflation:
   • Explanation: Inflation in India compared to other countries affects the real value of the rupee. If inflation in India is higher than in other countries, the real value of the rupee decreases because prices in India rise faster, reducing purchasing power.
   • Example: If India has 6% inflation while the U.S. has 2%, the real value of the rupee declines relative to the USD because Indian goods become more expensive compared to U.S. goods.
2. Productivity and Economic Growth:
   • Explanation: Higher productivity and economic growth can enhance the real value of the rupee by making Indian goods and services more competitive internationally.
   • Example: If Indian manufacturers improve their productivity, their goods may become cheaper and more competitive in global markets, potentially increasing the real value of the rupee.
3. Interest Rates:
   • Explanation: Higher interest rates in India compared to other countries can attract foreign capital, increasing demand for the rupee and potentially raising its real value.
   • Example: If the Reserve Bank of India (RBI) raises interest rates, it could attract foreign investors seeking higher returns, increasing the demand for INR and its real value.
4. Trade Balance:
   • Explanation: A trade surplus (exports > imports) can lead to an appreciation of the real value of the rupee, while a trade deficit can have the opposite effect.
   • Example: If India exports more goods and services than it imports, there is higher demand for INR to pay for Indian exports, which can appreciate the real value of the rupee.
5. Government Policies:
   • Explanation: Policies related to foreign exchange management, fiscal discipline, and economic reforms can impact the real value of the rupee.
   • Example: If the Indian government implements policies that lead to economic stability and growth, it can positively affect the real value of the rupee.

Real Effective Exchange Rate (REER)

Real Effective Exchange Rate (REER) is a measure that reflects the real value of a country’s currency against a basket of other major currencies, adjusted for inflation. It provides a comprehensive view of currency valuation and international competitiveness.

• Formula for REER:

REER=Nominal Effective Exchange Rate (NEER)×Domestic Price IndexForeign Price Index\text{REER} = \text{Nominal Effective Exchange Rate (NEER)} \times \frac{\text{Domestic Price Index}}{\text{Foreign Price Index}}REER=Nominal Effective Exchange Rate (NEER)×Foreign Price IndexDomestic Price Index​

• Nominal Effective Exchange Rate (NEER): An index that measures the weighted average of a country’s currency relative to a basket of other major currencies.
• Domestic Price Index: Measures the inflation rate within the country.
• Foreign Price Index: Measures the inflation rate in the trading partner countries.

Example of REER:

• Scenario: If India’s REER increases, it indicates that the real value of the rupee is rising relative to its trading partners. For instance, if the NEER index is stable but inflation in India is lower than in trading partner countries, the REER would rise, suggesting that Indian goods and services are becoming more expensive internationally. Conversely, a falling REER suggests that the rupee is becoming cheaper in real terms.

Examples of Real Value Adjustments

Example 1: Impact of Inflation on Real Value

• Scenario: Suppose the nominal exchange rate between the INR and USD is 1 USD = 80 INR. If inflation in India is 5% per year and inflation in the U.S. is 2%, the real value of the rupee decreases. This is because the prices of goods and services in India are rising faster than those in the U.S., eroding the purchasing power of the rupee.

Example 2: Productivity Gains Affecting Real Value

• Scenario: If India experiences significant improvements in its IT sector productivity, leading to reduced costs and increased exports, the real value of the rupee might appreciate. For example, if Indian software becomes cheaper and more competitive internationally, demand for INR increases as foreign buyers purchase more Indian software.

Example 3: Trade Balance Effects

• Scenario: Suppose India has a large trade surplus due to high export growth in pharmaceuticals. The increased demand for INR to pay for Indian exports can lead to an appreciation of the rupee’s real value. If the nominal exchange rate remains constant but the trade surplus leads to increased foreign demand for INR, the real value of the rupee increases.

Importance of the Real Value of the Rupee

1. Trade Competitiveness:
   • The real value of the rupee directly impacts India’s trade balance. A higher real value can make Indian goods and services more expensive abroad, potentially leading to a trade deficit, while a lower real value can make exports more competitive.
2. Investment Decisions:
   • Investors consider the real value of the rupee when making investment decisions. A stable or appreciating real value can attract foreign investment, while a depreciating real value might deter investors due to reduced purchasing power.
3. Monetary Policy:
   • The Reserve Bank of India (RBI) monitors the real value of the rupee to manage monetary policy. Changes in the real value can influence decisions on interest rates and foreign exchange interventions.

Conclusion

The real value of the rupee is a crucial concept for understanding its true purchasing power and international competitiveness. It accounts for inflation and price level differences, providing insights into how much goods and services the rupee can buy domestically and abroad. By examining factors like inflation, productivity, interest rates, and trade balance, policymakers and investors can better assess the real value of the rupee and its impact on the economy.