Exchange Rates, Interest Rates, And Inflation Rates In

7/28/2019 Exchange Rates, Interest Rates, And Inflation Rates In

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Journal of Transition Economics and Finance

ISSN 1986-4620 Issue 3 (2011)

EuroJournals Publishing, Inc. 2011

http://www.eurojournals.com/jtef.htm

Exchange Rates, Interest Rates, and Inflation Rates in

Indonesia: The International Fisher Effect Theory

Siti Rahmi Utami

Maastricht School of Management Endepolsdomein 150

6229 EP Maastricht, The Netherlands

E-mail: [email protected]; [email protected]

Eno L. Inanga

Maastricht School of Management Endepolsdomein 150

6229 EP Maastricht, The Netherlands

E-mail: [email protected]

Tel: +31 43 387 0808

Abstract

This paper tests and analyses the influence of interest rate differential on exchange

rate changes based on the International Fisher Effect theory and the influence of inflationrate and interest rate differentials in Indonesia. To test this theory, we use quarterly and

yearly data for the interest rates, inflation rate differentials, and changes in exchange ratesover a five-year period, 2003-2008. We chosen for our study four foreign countries,

namely, the USA, Japan, Singapore, and the UK, based on their levels of economic

development and industrialization, and Indonesia as the home country. Regression results

show that interest rate differentials have positive but no significant influence on changes inexchange rate for the USA, Singapore, and the UK relative to that of Indonesian. On the

other hand, interest rate differentials have negative significant influence on changes inexchange rates for Japan. Regression results also show that, overall, inflation rate

differentials have positive significant influence on interest rate differential.

Keywords: International Fisher Effect Theory, Exchange Rates, Interest Rates, and

Inflation Rates.

JEL Classification Codes: E40, E43

1. IntroductionThe International Fisher Effect (IFE) theory suggests that foreign currencies with relatively high

interest rates will tend to depreciate because the high nominal interest rates reflect expected rate of

inflation (Madura, 2000). This theory also proposes that changes in the spot exchange rate between two

countries will also tend to equate the differences in their nominal interest rates (Demirag and Goddard,1994).

Exchange rate control could be very costly, and even become pointless, when speculators attack

a currency, in even under government protection. High interest rate will prevent capital outflows,hinder economic growth and, consequently, hurt the economy (Solnik, 2000). Several factors could

cause exchange rate changes. These include changes in foreign exchange supply and demand, balance


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Journal of Transition Economics and Finance - Issue 3 (2011) 30

of payments problems, rising inflation, interest rate, national income, monetary supervision, changingexpectations and speculation (Khalwaty, 2000).

In linking exchange rate changes with changes in interest and inflation rates, the International

Fisher Effect theory states that the future spot rate of exchange can be determined from nominalinterest differential. The differences in anticipated inflation that are embedded in the nominal interest

rates are expected to affect the future spot rate of exchange (Sundqvist, 2002). Therefore this study will

test and analyse the influence of interest rate differentials on change in exchange rates based on the IFE

theory and previous studies (Thomas, 1985 ; Sundqvist, 2002 ; and Hakkio, 1986), and the influence ofinflation rate on interest rate differential as studied by Miyagawa and Morita (2003), Jensen (2006),

Peng (1995), Mishkin (1984), Cooray (2002), and Crowder (2003).In the process of doing so, we will also test the extent to which the IFE theory is applicable to

the Indonesian economy. Specifically, the study will attempt to answer the question, To what extent

does high nominal interest rate reflect high level of expected inflation in the Indonesian economy ?

Based on the IFE theory, if we combine inflation rate with interest rate, we should expect high interestrate to result in a weaker currency.

To test the applicability of this theory to the Indonesian economy, we will use quarterly and

yearly data for the interest rate differentials, inflation rate differentials, and changes in exchange ratesover a 5-year period of 2003 to 2008. We have chosen as foreign countries the USA, Japan, Singapore,

and the UK based on their levels of economic development and industrialization. Indonesia is chosenas the home country.

The rest of this paper is structured in 5 sections. Section 2 reviews relevant literature on the

International Fisher Effect theory, and highlights some of the empirical findings of other similar

studies. In section 3 we state the hypotheses based on these studies. Section 4 discusses the research

methodology and data used for the study. Sections 5 and 6 present the study results and conclusionsrespectively.

2. Literature ReviewThe International Fisher Effect (IFE) theory explains the relationship between the interest rate

differentials of two countries and the expected exchange rate changes. The derivation of thisrelationship according to the IFE is that the actual return to investors who invest in money market

securities in their home country are the foreign interest rate and the change in the foreign currency

value (Madura, 2000).The formula of the actual return which also called effective (exchange rate adjusted) return is

1 1 1f fr i e , where ris the actual returns to investors, if is the foreign interest rate, and efisthe percentage change in the value of the foreign currency denominating the security (Madura, 2000).

The International Fisher Effect theory therefore suggests that the expected return on a foreign

money market investment, E r , should be equal to the interest rate on a local money market

investment, hi

, since on average, the effective return on a foreign investment should be equal to the

effective return on a domestic investment in equilibrium. Thereby E r is made equal to hi , hE r i .

In order to make investments in both home and foreign countries to yield similar returns, ris set

equal to ih, and the foreign currency must change to make hr i . Therefore 1 1 1f hi e i ,where ris the effective return on the foreign deposit and ih is the interest rate on the home deposit. The

formula of ih is expressed as 1 1 1f f hi e i , and

1

11

h

f

f

ie

i

, to determine for the

foreign currency value (ef). Finally, the International Fisher Effect function would be formulated as:


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31 Journal of Transition Economics and Finance - Issue 3 (2011)

1

11

h

f

f

ie

i

(Model 1)

Hence, the IFE theory concludes that when home interest rate is higher than foreign interest

rate, the foreign currency value will be positive, since the relatively low foreign interest rate reflectsrelatively low inflationary expectations in the foreign country. The foreign currency will then

appreciate, as the foreign interest rate will be lower than the domestic interest rate. This appreciation

would then increase the foreign returns to investors in the home country, thereby moving returns onforeign securities close to returns on home securities. If, on the other hand, when home interest rate is

lower than foreign interest rate, the foreign currency value will be negative, because the foreign

currency will depreciate when the foreign interest rate exceeds the domestic interest rate. Thisdepreciation will tend to reduce the returns on foreign financial securities and make them unattractive

to domestic investors in the financial securities in the home country money market to yield higher

returns.

The IFE theory is the international counterpart of the Fisher Effect. It can be seen as acombination of the generalized version of the Fisher Effect and the relative version of the Purchasing

Power Parity (Sundqvist, 2002). The generalized version of the Fisher Effect specifies a relationship

between interest rates differential of two countries and their inflation rates differential. Countries with

high rates of inflation should have higher nominal interest rates than countries with lower rates ofinflation.

Madura (2000) also aligns that the International Fisher Effect theory closely with thePurchasing Power Parity (PPP) theory because of the often observed high correlation of interest rates

with inflation rates. The PPP theory suggests that the changes in exchange rate are caused by the

inflation rate differentials. While any difference in nominal interest rates would be attributable to the

difference in expected rates of inflation, the real interest rates are the same across countries, as Fisherequation implies that the nominal interest rate is equal to the real interest rate plus the expected rate of

inflation. Meanwhile, the IFE theory suggests that relatively high interest rates of foreign currencies

will depreciate because high nominal interest rates tend to reflect expected inflation.In order to demonstrate the relationship between relative inflation rates and exchange rates

according to the PPP, model 2 is expressed as follows:

1

11

h

f

f

Ie

I

(Model 2)

Model 2 indicates that when home inflation rate,Ih, is higher than foreign inflation rate, If, the

foreign currency value will be positive, implying that foreign currency will tend to appreciate whendomestic inflation rate exceeds the foreign inflation rate. Conversely, if home inflation rate is lower

than foreign inflation rate, the foreign currency value will be negative. This implies that the foreign

currency value will depreciate when the foreign countrys inflation rate exceeds that of the home

country.Since the generalized version of the Fisher Effect specifies a relationship between interest rates

differential and inflation rates differential, we get :

1 1

1 11 1

h h

f f

i I

i I

(Model 3)

By combining model 1 and model 2, we have :

1 1

1 11 1

h h

f

f f

i Ie

i I

(Model 4)


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The value of the foreign currency, ef, will be formulated as1t t

t

S S

S

to determine the change in

its value. Therefore, model 4 and 5 are expressed to show how the exchange rate change, interest rate,

and inflation rate differentials are related :

, , , ,1

, ,1 1

h t f t h t f t t t

t f t f t

i i I I S S

S i I

(Model 5)1

Where 1tS is the spot exchange rate at time t+1, tS is the domestic currency value of one unit

of foreign currency at time t, ,h ti is interest rate at time t in the home country, ,f ti is interest rate at time

t in the foreign country, ,h tI is inflation rate at time t in the home country, ,f tI is inflation rate at time t

in the foreign country.Recently there have been many studies of the International Fisher Effect and the Fisher Effect

theories, such as the research by Crowder (2003), who used data from several sources for his studies.

These sources included the OECD Main Economic Indicators, monthly observations on short-termnominal interest rates and CPI inflation data. The study focused on eight industrialized countries and

covered a period of over three decades from January 1960 to August 1993. The interest rates and

inflation rates were converted to annualized values. The Belgian interest rate was the three-monthtreasury certificates. The German interest rate was the FIBOR rate. The French, British and Dutch

nominal interest rates were the call money rates. The Italian rate used was the Treasury bond rate with

a 6-year average maturity. The Japanese and American nominal interest rates used were three-month

treasury bill rates. He analyzed the Fisher relation for these industrialized countries over the studyperiod. He found clear evidence that supports the Fisher theory in all the eight countries.

The research by Cooray (2002), surveyed the literature on the Fisher Effect. He stated that

while the majority of early studies confirmed Fishers findings of a distributed lag structure in theformation of expectations, the evidence in respect of the models based on the theories of rational

expectations and efficient markets was mixed. He concluded that, although studies for the US appear to

suggest a positive relationship between interest rates and inflation, they did not establish a one-to-onerelationship as postulated by Fisher. He explained further that the evidence for the US seemed broadly

consistent with suggestions of the Fisher Effect, while results for other developed nations are not so

clear-cut. Studies for the developing nations suggest a high degree of consistency in results for the

Latin American countries with significant evidence of a Fisher Effect.Crowder and Sonora (2002), in their study, used a data set on local city-wide interest rates and

local mortgage interest rates to construct a panel of Fisher relationships within the United States. In

their study, they attempted to exploit the cross-sectional information in a panel of Fisher equationsfrom different cities across the U.S. in the hope of yielding better estimates of the Fisher Effect in order

to determine whether or not real rates of interest are stationary, as implied by economic theory. The

research results were decidedly mixed. On the positive side, they found almost no evidence of non-stationarity in the real interest rate.

The International Fisher Effect study by Sundqvist (2002), involved empirical investigation

using quarterly data for the nominal interest rates and exchange rates from different industrialized

countries over the period between 1993 and 2003. For the study, he selected Sweden, Japan, UK,Canada, and Germany, countries with floating exchange rates, for a comparative study with the US. He

used regression analysis to examine the nominal interest differentials and the exchange rates change in

these countries. He concluded that the International Fisher Effect was only valid for the US and Japan.Mishkin (1984) studied the real interest rate movements in seven OECD countries for the

period 1967 to 1979 in the euro deposit market. He found a close relationship between nominal interest

rates and expected rates of inflation for the UK, the US and Canada. He found that Germany, the

1 The change in exchange rate and the interest rate differential models are also used by Sundqvist (2002).


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countries, namely, the US, Japan (JAP), Singapore (SING), and the UK, on home country,

Indonesia (IND), by using the following regression models :

/USD IDR IND US Y X

(Model 6)

/JPY IDR IND JAPY X

(Model 7)

/SGD IDR IND SINGY X

(Model 8)

/GBP IDR IND UK Y X

(Model 9)

Where Y is the change in exchange rate, 1t t

t

S S

S

, and X is the interest rate differential,

, ,

,1

h t f t

f t

i i

i

.

b. Based on the studies of Miyagawa and Morita (2003), Jensen (2006), Peng (1995), Mishkin(1984), Cooray (2002), and Crowder (2003), we test the hypothesis 2 by applying the followingregression model :

Y X (Model 10)

WhereX is the inflation rate differential,

, ,

,1

h t f t

f t

I I

I

, and Y is the interest rate differential,

, ,

,1

h t f t

f t

i i

i

.

4.2. Data Analysis

We will employ regression technique to analyze the data. The technique will then be applied, firstly tothe interest rate differential and the change in exchange rate, and secondly, to the inflation rate

differential on interest rate differential. The regression analysis tests whether interest rate differential is

a good forecast for change in the future spot exchange rates based on the International Fisher Effecttheory, and the influence of inflation rate differential on interest rate differential based on the Fisher

Effect theory.

4.3. Data Description

We have chosen 4 foreign industrialized countries for our study. These are the US, Japan, Singapore,

and the UK, with Indonesia as the home country. We have collected macroeconomic data from theCentral Bank of Indonesia

2(BI) for a period of five years from 2003 to 2008. Data on interest rate is

the international interest rate. For the US and Japan we use yearly interest rate data. But for the UK, we

use LIBOR 3-month interest rate. For Singapore, we chose SIBOR 3-month interest rate, while for

Indonesia we use JIBOR 3-month interest rate. For exchange rate and interest rate data, we usequarterly data from 2006 to 2008, and yearly data from 2003 to 2007.

5. Hypotheses Testing Results5.1. Testing Results of Hypothesis 1a

Table 1 and 2 show model summary and coefficients for Indonesia-US interest rate differential to

change in the exchange rate based on regression model 6.

2 www.bi.go.id


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Table 1: Model Summary for Indonesia-US Interest Rate Differential to Change in the Exchange Rate

.010a .000 -.037 .03735 2.515

Model1

RR

SquaredAdjusted

R SquaredStd. Error ofthe Estimate

Durbin-Watson

Predictors: (Constant), i_INDtoUSa.

The actual R-Squared value is 0.0001, but the coloumn can only consist of 4 digits.

Table 1 shows the coefficient of determination, or simply R-squared. Its value is alwaysbetween 0 and 1, and interpreted as the percentage of variation in the response variables explained by

the regression line. R-squared3

shows a predictor interest rate differential between Indonesia and the

US of 0.0001 with the change in exchange rate as dependent variable. This means that only 0.01 % ofthe change in exchange rate of USD/IDR could be explained by the interest rate differential while

99.99% would be explained by other factors.

Table 2: Coefficients for Indonesia-US Interest Rate Differential to Change in the Exchange Rate

.000 .010 .020 .984

.001 .024 .010 .054 .957

(Constant)

i_INDtoUS

Model1

B Std. Error

UnstandardizedCoefficients

Beta

StandardizedCoefficients

t Sig.

Actual constant -value shows in the table 2 is 0.0002

Table 2 above shows that the interest rate differential has positive but not significant influence

on change in the exchange rate, with 0.957 level of significance and 0.054 t-value, 0.0002 constant -value

4and 0.001 -value. The constant -value explains that the USD/IDR exchange rate will change

by 0.0002 % when Indonesia-US interest rate differential equals zero. The increase in interest rate

differential could be caused by the increase in interest rate of the home country, Indonesia, or thedecrease in interest rate of the foreign country, the US. The positive t-value indicates that when interest

rate differential is higher, IDR tend to depreciate against the USD as explained by the International

Fisher Effect theory. If the sign of change in exchange rate is positive, it would imply that IDR isdepreciating. On the other hand, if the sign of change in exchange rate is negative, the implication

would be that IDR is appreciating against USD.

5.2. Testing Results of Hypothesis 1b

Table 3 and 4 show model summary and coefficients for Indonesia-Japan interest rate differential to

change in the exchange rate based on regression model 7.

Table 3: Model Summary for Indonesia-Japan Interest Rate Differential to Change in the Exchange Rate

.366a .134 .102 .04844 2.064Model1 RR

Squared

Adjusted

R Squared

Std. Error ofthe Estimate

Durbin-

Watson

Predictors: (Constant), i_INDtoJ APa.

3 R-Squared shows in the table 1 with a predictor Indonesia-US interest rate differential and change in the exchange rate as

dependent variable, is 0.000. The actual value is 0.0001, but the coloumn can only consist of 4 digits.4 Actual constant -value shows in the table 2 is 0.0002.


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Table 3 shows R-squared, a predictor of interest rate differential between Indonesia and Japan

of 0.134, with change in exchange rate as dependent variable. This means that 13.4% of the exchange

rate change of JPY/IDR could be explained by the interest rate differential, while 86.6% are caused by

other factors.

Table 4: Coefficients for Indonesia-Japan Interest Rate Differential to Change in the Exchange Rate

.071 .033 2.186 .038

-.030 .015 -.366 -2.043 .050

(Constant)

i_INDtoJAP

Model1

B Std. Error


Beta


t Sig.

Table 4 shows that the interest rate differential between Indonesia and Japan has negative

significant effect on the exchange rate change, with 0.050 level of significance and -2.043 t-value,

0.071 constant -value, and -0.030 -value. The constant -value explains that if interest rate inIndonesia and Japan are the same, the change in exchange rate would be 0,071%. The negative t-value

indicates that when interest rate differential is higher, IDR would appreciate against the JPY. Hence, if

the sign of change in exchange rate is positive, then IDR will appreciate. On the other hand, if the signof change is negative, it will imply that IDR is depreciating against JPY. This finding is contrary with

the International Fisher Effect theory.

5.3. Testing Results of Hypothesis 1c

Table 5 and 6 show model summary and coefficients for Indonesia-Singapore interest rate differential

to change in the exchange rate based on regression model 8.

Table 5: Model Summary for Indonesia-Singapore Interest Rate Differential to Change in the Exchange Rate

.026a .001 -.036 .03712 2.388

Model1

RR

SquaredAdjusted


Durbin-Watson

Predictors: (Constant), i_INDtoSINGa.

Table 5 shows R-squared, a predictor interest rate differential between Indonesia and Singapore

of 0.001 with the change in exchange rate as a dependent variable. This means that 0.1 % of the change

in exchange rate of SGD/IDR could be explained by the interest rate differential and 99.90 % would beexplained by other factors.

Table 6: Coefficients for Indonesia-Singapore Interest Rate Differential to Change in the Exchange Rate

.012 .012 .997 .328

.001 .010 .026 .135 .894

(Constant)

i_INDtoSING

Model1

B Std. Error


Beta


t Sig.

Table 6 above shows the interest rate differential that has positive but not significant influenceon the exchange rate change, with 0.894 level of significance and 0.135 t-value, 0.012 constant -

value, and 0.001 -value. The interpretation of the constant -value is that SGD/IDR exchange rate


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will change by 0.012 % when the Indonesia-Singapore interest rate differential equals zero. The

positive t-value means that when interest rate differential is higher, IDR would tend to depreciate

against SGD as implied by the International Fisher Effect theory. If the sign of change in exchange rate

is positive, it indicates that IDR is depreciating. On the other hand, if the sign of change in exchangerate is negative, it shows that IDR is appreciating against SGD. Meanwhile, the increase in interest rate

differential could be caused by the increase in the interest rate of the home country, Indonesia, or the

decrease in the interest rate of the foreign country, Singapore.

5.4. Testing Results of Hypothesis 1d

Table 7 and 8 show model summary and coefficients for Indonesia-UK interest rate differential tochange in the exchange rate based on regression model 9.

Table 7: Model Summary for Indonesia-UK Interest Rate Differential to Change in the Exchange Rate

.299a .089 .056 .04267 2.544

Model1

RR

SquaredAdjusted


Durbin-Watson

Predictors: (Constant), i_INDtoUKa.

Table 7 shows the R-squared, a predictor interest rate differential between Indonesia and the

UK of 0.089 with the change in exchange rate as dependent variable. This means that 8.9 % of thechange in exchange rate of GBP/IDR could be explained by the interest rate differential and 91.1 % by

other factors.

Table 8: Coefficients for Indonesia-UK Interest Rate Differential to Change in the Exchange Rate

-.005 .014 -.340 .736

.018 .011 .299 1.629 .115

(Constant)

i_INDtoUK

Model1

B Std. Error

Unstandardized

CoefficientsBeta

Standardized

Coefficientst Sig.

In table 8 the interest rate differential has positive but not significant effect on the exchange ratechange, with 0.115 significance level and 1.629 t-value, -0.005 constant -value and 0.018 -value.

The constant -value implies that if interest rates in Indonesia and the UK are the same, the change in

exchange rate would be -0.005 %. The positive t-value illustrates that when interest rate differential ishigher, IDR would depreciate against GBP. If the sign of exchange rate change is positive, it would

imply that IDR is depreciating. On the other hand, if the sign of the change in exchange rate isnegative, it explains that IDR is appreciating on GBP. The increase in interest rate differential could be

caused by the increase in the interest rate of the home country, Indonesia, or the decrease in the interestrate of the foreign country, the UK.

5.5. Testing Results of Hypothesis 2

Table 9 and 10 show model summary and coefficients of inflation rate differential to interest rate

differential based on regression model 10.


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Table 9: Model Summary of Inflation Rate Differential to Interest Rate Differential

.515a .265 .247 .94734 1.266

Model1

RR

SquaredAdjusted


Durbin-Watson

Predictors: (Constant), InflationRatesa.

Table 9 also shows the R-squared, a predictor inflation rate differential for Indonesia-US,Indonesia-Japan, Indonesia-Singapore, and Indonesia-UK of 0.265 with interest rate differential as

dependent variable. This means that 26.5 % of interest rates differential could be explained by theinflation rates differential and 73.5 % by other factors.

Table 10: Coefficients of Inflation Rate Differential to Interest Rate Differential

1.773 .195 9.098 .000

.105 .027 .515 3.843 .000

(Constant)

InflationRates

Model1

B Std. Error


Beta


t Sig.

Table 10 displays that inflation rate differential has positive significant influence on interestrate differential, with 0.000 level of significance and 3.843 t-value, 1.773 constant -value, and 0.105

-value. The description of the constant -value is that the interest rate differential will change by

1.773 % when the inflation rate differential equals zero. Meanwhile, the positive t-value shows that thehigher the inflation rate differential between Indonesia-US, Indonesia-Japan, Indonesia-Singapore, and

Indonesia-UK, the higher the interest rate differential between them. The increase in interest ratedifferential could be caused by the increase in interest rate of the home country, or the decrease in the

interest rate of the four foreign countries. The increase in inflation rate differential could be also caused

by the increase in inflation rate of the home country, Indonesia, or the decrease in inflation rate of

those foreign countries, the US, Japan, Singapore, and the UK.

5.6. The Interest Rate Differential and Change in the Exchange Rate

Figure 1, 2, 3, and 4 show the movement of IndonesiaUS, IndonesiaJapan, IndonesiaSingapore, and

IndonesiaUK interest rate differentials and changes in the exchange rate.

Figure 1: IndonesiaUS Interest Rate Differential and Change in Exchange Rate

interest rate differential

exchange rate change

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

2003 2004 2005 2006 2007


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Figure 2: IndonesiaJapan Interest Rate Differential and Change in Exchange Rate

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

2003 2004 2005 2006 2007

Figure 3: IndonesiaSingapore Interest Rate Differential and Change in Exchange Rate


exchange rate change

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

2003 2004 2005 2006 2007

Figure 4: IndonesiaUK Interest Rate Differential and Change in Exchange Rate

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

2003 2004 2005 2006 2007


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Figure 1, 3, and 4 display the interest rate differentials between Indonesia-US, Indonesia-

Singapore, and Indonesia-UK interest rates, and as well as the exchange rate changes between the these

countries. As in 2005 interest rate in the home country hit the highest level within the period of

research, figure 1 shows that the highest interest rate differential between Indonesia and the USoccurred in 2005, and the lowest in 2007. Meanwhile, the highest IDR depreciation was in 2004, and

the lowest in 2003.

Figure 2 shows Indonesia-Japan interest rate differential and the exchange rate change.

Consistent with the result of Indonesia-US, figure 2 indicates that the highest interest rate differentialbetween Indonesia-Japan was also in 2005, and the lowest rate in 2007. Meanwhile, the highest IDR

appreciation against JPY was in 2004, and the lowest appreciation was in 2006.We can observe from the figure 3 that the year of the highest IDR depreciation against SGD

was in 2004, and the lowest in 2003. As the interest rates of the two foreign countries, Singapore and

the UK, reached the lowest level in 2003 and the highest level in 2007, these rates have caused the

highest interest rate differentials between Indonesia-Singapore (figure 3) and Indonesia-UK (figure 4)occurred in 2003, and the lowest in 2007. However, the highest depreciation of the IDR against GBP

occurred in 2004, while the lowest took place in 2005.

5.7. The Inflation Rate and Interest Rate Differentials

Figure 5, 6, 7, and 8 show the movement of IndonesiaUS, IndonesiaJapan, IndonesiaSingapore, and

IndonesiaUK inflation rates and interest rates differentials.

Figure 5: IndonesiaUS Inflation and Interest Rate Differentials


0

0.5

1

1.5

2

2.5

3

3.5

2003 2004 2005 2006 2007

Inflation rate differential

Figure 6: IndonesiaJapan Inflation and Interest Rate Differentials

0

2

4

6

8

10

12

14

16

18

20

2003 2004 2005 2006 2007


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Figure 7: IndonesiaSingapore Inflation and Interest Rate Differentials


Inflation rate differential

0

1

2

3

4

5

6

7

8

2003 2004 2005 2006 2007

Figure 8: IndonesiaUK Inflation and Interest Rate Differentials

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2003 2004 2005 2006 2007

Figure 5 displays the inflation rate and interest rate differentials between Indonesia and the US.The highest inflation rate differential between Indonesia and the US was in 2006, while the lowest was

in 2007. The same result also shown by figure 8 for Indonesia-UK inflation rate differential.

Meanwhile, the highest Indonesia-US interest rate differential was in 2005, and the lowest rate was in2007. However, the highest Indonesia-UK interest rate differential was registered in 2003, and the

lowest in 2007 as illustrated by figure 8.

The inflation rate and interest rate differentials between Indonesia and Japan are shown in

figure 6. It indicates that the highest inflation rate differential between Indonesia and Japan was in2005, and the lowest rate in 2004. The highest interest rate differential was in 2005, and the lowest in

2007.Figure 7 displays the inflation rate differential between Indonesia and Singapore, as well as the

interest rate differential between the two countries. In addition, the figure indicates that the highest

inflation rate differential between Indonesia and Singapore was in 2005, and the lowest rate in 2007.

Meanwhile, the highest interest rate differential was in 2003, while the lowest rate was in 2007.Hence, overall we conclude that the year with the lowest interest rate and inflation rate

differentials within the sampling period was in 2007, as the regression result shows that the inflation

rate differential has a positive effect on the interest rate differential.


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6. ConclusionOur regression results have shown that the interest rate differentials have positive but not significant

influence on the US, Singapore, and the UK exchange rate changes relative to Indonesian currency.

The implication of these results is that the higher the interest rate differentials between Indonesia and

these countries, the higher the change in exchange rate. We can therefore argue that, when interest ratedifferential is higher, IDR would depreciate against USD, SGD, and GBP. This evidence concludes

that the International Fisher Effect holds but is not significant for the US, Singapore, and the UK.

On the other hand, the interest rate differential has negative significant influence on the changein exchange rate for Japan. Therefore, when interest rate differential is higher, IDR would appreciate

against JPY. But, this finding is not consistent with what suggested by the International Fisher Effecttheory as when home interest rate is higher than foreign interest rate the foreign currency value will

appreciate. Therefore the theory also does not hold in Japan.

Based on these results, a conclusion that can be drawn is that the interest rate differential mightnot be applied accurately to predict the change in future exchange rate based on a quarterly or yearly

sample, such as ours in this study which covered the period 2003 to 2008, as suggested by the

International Fisher Effect theory.Regression results also show that the inflation rate differential has positive significant influence

on the interest rate differential, thereby indicating that when inflation rate differential increases, the

interest rate differential will also increase. This means that the Fisher Effect holds for inflation rate andinterest rates differentials in Indonesia against the four study foreign countries of USA, Japan,Singapore, and the UK.

Meanwhile, R-squared for Indonesia and Japan would seem much more accurate than those of

the other three countries. The overall R-squared, with interest rate differential as dependent, andinflation rate differential as independent variable is also a much better predictor of interest rate

differential. However, the beta values for all country pairs in our study are very low. This implies a

reaction of the change in exchange rate to other factors in addition to nominal interest rate differential.Another possible explanation could be failure of change in exchange rate to offset nominal interest rate

differentials.

References[1] Abuaf, Niso and Philippe Jorion, 1990. Purchasing Power in the Long Run, Journal of

Finance 45, 1 (March), pp. 157-174.

[2] Adler, Michael and Bernard Dumas, 1983. International Portfolio Choice and CorporateFinance: A Synthesis,Journal of Finance 38, 3 (June), pp. 925-984.

[3] Adler, Michael and Lehman Bruce, 1983. Deviations from Purchasing Power Parity in theLong Run,Journal of Finance 39, 5 (December), pp. 1471-1487.

[4] Cooray, Arusha, 2002. The Fisher Effect : A Review of the Literature, Economics ResearchPaper, Macquarie University, No.0206, pp. 1-25.

[5] Crowder, William J. and Robert J. Sonora, 2002. Intra-National Evidence of the Fisher

Effect, Working Paper, University of Texas at Arlington, pp. 1-47.[6] Crowder, William J., 2003. International Evidence on the Fisher Relation, Working Paper,

University of Texas at Arlington, pp. 1-17.

[7] Demirag, I and S. Goddard, 1994. Financial Management for International Business, McGraw-Hill Book Company, Berkshire, Europe.

[8] Fisher, I., 1930. The Theory of Interest, MacMillan, New York.[9] Hakkio, Craig S., 1986. Interest Rates and Exchange Rates-What Is the Relationship?,

Economic Review, Federal Reserve Bank of Kansas City, issue (November), pp. 33-43.[10] Jensen, Mark J., 2006. The Long-Run Fisher Effect: Can It Be Tested?, Working Paper,

Federal Reserve Bank of Atlanta 11 (August), pp. 1-16.


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[11] Johansen, S., 1988. Statistical Analysis of Cointegration Vectors, Journal of EconomicDynamics and Contro 12, pp. 231254.

[12] Johansen, S. and K. Juselius, 1990. Maximum Likelihood Estimation and Inference onCointegration with Applications to the Demand for Money, Oxford Bulletin of Economics

and Statistics 52, pp. 169210.

[13] Khalwaty, Tajul, 2000. Inflation and Solutions, 1st Edition. Gramedia Pustaka Utama,Indonesia.

[14] King, R. and M. Watson, 1997. Testing Long-Run Neutrality, Federal Reserve Bank ofRichmond Economic Quarterly 83, pp. 69-101.

[15] Koustas, Z. and A. Serletis, 1999. On the Fisher effect, Journal of Monetary Economics 44,pp. 105-130.

[16] Madura, Jeff, 2000. International Financial Management, 6th Edition, South-Western CollegePublishing.

[17] Mishkin, Frederic S., 1984. Are Real Interest Rates Equal Across countries? An EmpiricalInvestigation of International Parity Conditions.Journal of Finance 39, pp. 13451357.

[18] Mishkin, F. S and J. Simon, 1995. An Empirical Examination of the Fisher Effect inAustralia,NBER Working PaperNo.5080, NBER, MA.

[19] Miyagawa, Shigeyoshi and Yoji Morita, 2003. The Fisher Effect and The LongRun Phillips

Curve in the Case of Japan, Sweden and Italy, Working Paper in Economics, Kyoto GakuenUniversity 77 (March), pp. 1-20.

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[21] Rapach, D.E., 2003. International Evidence of the Long-Run Impact of Inflation, Journal ofMoney, Credit, and Banking 35, pp. 23-48.

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[23] Solnik, B., 2000. International Investment, Addison Wesley Longman, Inc, New York.[24] Sundqvist, Emil, 2002. An Empirical Investigation of the International Fisher Effect, Social

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AppendixRegression Results

Table 1: Descriptive Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change

.0006 .03668

.2824 .29603

S_IDRtoUSD

i_INDtoUS

Mean Std. Deviation


16/19


Table 2: Correlations for Indonesia-US Interest Rate Differential and Exchange Rate Change

1.000 .010

.010 1.000

. .479

.479 .

29 29

29 29

S_IDRtoUSD

i_INDtoUS

S_IDRtoUSD

i_INDtoUS

S_IDRtoUSD

i_INDtoUS

Pearson Correlation

Sig. (1-tailed)

N

S_IDRtoUSD i_INDtoUS

Table 3: Anova for Indonesia-US Interest Rate Differential and Exchange Rate Change

.000 .000 .003 .957a

.038 .001

.038

Regression

Residual

Total

Model1

Sum ofSquares Mean Square F Sig.

Predictors: (Constant), i_INDtoUSa.

Table 4: Residual Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change

.0002 .0017 .0006 .00038

-.09741 .09651 .00000 .03668

-1.053 2.901 .000 1.000

-2.608 2.584 .000 .982

Predicted Value

Residual

Std. Predicted Value

Std. Residual

Minimum Maximum Mean Std. Deviation

Table 5: Descriptive Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate

Change

.0072 .05111

2.1516 .62860

S_IDRtoJ PY

i_INDtoJ AP

Mean Std. Deviation

Table 6: Correlations for Indonesia-Japan Interest Rate Differential and Exchange Rate Change

1.000 -.366

-.366 1.000

. .025

.025 .

29 29

29 29

S_IDRtoJPY

i_INDtoJAP

S_IDRtoJPY

i_INDtoJAP

S_IDRtoJPY

i_INDtoJAP

Pearson Correlation

Sig. (1-tailed)

N

S_IDRtoJP Y i_INDtoJAP


17/19


Table 7: Anova for Indonesia-Japan Interest Rate Differential and Exchange Rate Change

.010 .010 4.173 .050a

.063 .002

.073

Regression

Residual

Total

Model1


Predictors: (Constant), i_INDtoJ APa.

Table 8: Residual Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate

Change

-.0748 .0257 .0072 .01870

-.09649 .13537 .00000 .04757

-4.386 .989 .000 1.000

-1.992 2.795 .000 .982

Predicted Value

Residual


Std. Residual


Table 9: Descriptive Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate

Change

.0133 .03646

.9921 .70953

S_IDRtoSGD

i_INDtoSING

Mean Std. Deviation

Table 10: Correlations for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change

1.000 .026

.026 1.000

. .447

.447 .

29 29

29 29

S_IDRtoSGD

i_INDtoSING

S_IDRtoSGD

i_INDtoSING

S_IDRtoSGD

i_INDtoSING

Pearson Correlation

Sig. (1-tailed)

N

S_IDRtoSGD i_ INDtoSING

Table 11: Anova for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change

.000 .000 .018 .894a

.037 .001

.037

Regression

Residual

Total

Model1


Predictors: (Constant), i_INDtoSINGa.


18/19


Table 12: Residual Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate

Change

.0125 .0164 .0133 .00095

-.06454 .12751 .00000 .03645

-.855 3.331 .000 1.000

-1.739 3.435 .000 .982

Predicted Value

Residual


Std. Residual


Table 13: Descriptive Statistics for Indonesia-UK Interest Rate Differential and Exchange RateChange

.0136 .04391

.9951 .71327

S_IDRtoGBP

i_INDtoUK

Mean Std. Deviation

Table 14: Correlations for Indonesia-UK Interest Rate Differential and Exchange Rate Change

1.000 .299

.299 1.000

. .058

.058 .

29 29

29 29

S_IDRtoGBP

i_INDtoUK

S_IDRtoGBP

i_INDtoUK

S_IDRtoGBP

i_INDtoUK

Pearson Correlation

Sig. (1-tailed)

N

S_IDRtoGBP i_INDtoUK

Table 15: Anova for Indonesia-UK Interest Rate Differential and Exchange Rate Change

.005 .005 2.652 .115a

.049 .002

.054

Regression

Residual

Total

Model1


Predictors: (Constant), i_INDtoUKa.

Table 16: Residual Statistics for Indonesia-UK Interest Rate Differential and Exchange Rate Change

.0024 .0575 .0136 .01313

-.09204 .14954 .00000 .04190

-.854 3.337 .000 1.000

-2.157 3.504 .000 .982

Predicted Value

Residual


Std. Residual



19/19


Table 17: Descriptive Statistics of Inflation Rate and Interest Rate Differential

2.2749 1.09160

4.7820 5.34761

InterestRates

InflationRates

Mean Std. Deviation

Table 18: Correlations of Inflation Rate and Interest Rate Differential

1.000 .515

.515 1.000

. .000

.000 .

43 43

43 43

InterestRates

InflationRates

InterestRates

InflationRates

InterestRates

InflationRates

Pearson Correlation

Sig. (1-tailed)

N

InterestRates InflationRates

Table 19: Anova of Inflation Rate and Interest Rate Differential

13.251 13.251 14.765 .000a

36.796 .897

50.047

Regression

Residual

Total

Model1


Predictors: (Constant), InflationRatesa.

Table 20: Residual Statistics of Inflation Rate and Interest Rate Differential

1.8981 4.9938 2.2749 .56170

-2.07615 2.32436 .00000 .93600

-.671 4.840 .000 1.000

-2.192 2.454 .000 .988

Predicted Value

Residual


Std. Residual


Documents

Exchange Rates, Interest Rates, And Inflation Rates In