External Sector of India

Definition: Forex reserves are assets held on reserve by a central bank in foreign currencies like dollar, which can include bonds, treasury bills and other government securities.
Components:
- Foreign Currency Assets
- Gold reserves
- Special Drawing Rights
- Reserve position with the International Monetary Fund (IMF)
Significance:
- Show health of economy
- Help to sustain trade in economic emergency situation
- Provides the capacity to intervene in support of the national or union currency.

Definition: NIIP is the difference between a country’s foreign assets and foreign liabilities.
Components:
- Foreign Assets: Investments held by a country’s residents in foreign countries.
- Foreign Liabilities: Debts or investments owed to foreign entities.
Positive NIIP: When foreign assets exceed foreign liabilities, the country is a net creditor.
Negative NIIP: When foreign liabilities exceed foreign assets, the country is a net debtor.

Definition: The exchange rate is the price at which one currency can be exchanged for another. It determines how much of one currency is needed to buy a unit of another currency.
Types of Exchange Rates:
- Fixed Exchange Rate: The value of a currency is tied or pegged to another major currency (like the U.S. dollar or gold). The central bank intervenes to maintain the currency’s value.
- Floating Exchange Rate: The value of the currency is determined by the market forces of supply and demand. Central banks do not directly intervene to set the rate.
- Managed Float Exchange Rate: A combination of fixed and floating, where the exchange rate is largely determined by market forces but the central bank occasionally intervenes to stabilize the currency.

Nominal Effective Exchange Rate (NEER): The Nominal Effective Exchange Rate (NEER) is an index that represents the weighted average of a country’s currency value relative to a basket of other major currencies. It reflects the nominal exchange rates without adjusting for inflation.
Real Effective Exchange Rate (REER): The Real Effective Exchange Rate (REER) is an index that measures a country’s currency value relative to a basket of other currencies, adjusted for inflation (domestic and foreign). It reflects the real purchasing power of the currency in international markets.