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Exchange Rate Overshooting in Indonesia
Exchange Rate Overshooting in Indonesia
Exchange Rate Overshooting in Indonesia
UNIVERSITAS INDONESIA
MAKALAH
UJIAN AKHIR SEMESTER
EKONOMI KEUANGAN INTERNASIONAL
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Pembuat Pernyataan,
Mohamad E. Fokkerizky
1606884672
EXCHANGE RATE OVERSHOOTING IN INDONESIA
Mohamad E. Fokkerizky
Fakultas Ekonomi dan Bisnis Universitas Indonesia
mohamad.elang@ui.ac.id
inflation rates and stable exchange rates. This will spur an increase in investment, consumption
and international trade which will ultimately have an impact on economic growth. Economic
growth will also depend on the international monetary system applied to the country. The
selection of a good international monetary system aims to reduce or minimize risks from
exchange rate fluctuations that will have an influence on the economy of the country where any
changes in exchange rates will have an impact on the country's economic activity. One
application of the international monetary system is the application of a free floating exchange
In theory, in a fully floating exchange rate system monetary policy will be more effective
the pressure of the Rupiah exchange rate occurs as an effect monetary policy will be adjusted
through the influence of interest rates on capital flows and the effect of changes in the Rupiah
exchange rate against export offers and import demand. Through this mechanism, the current
account balance will function as an important adjustment mechanism so that the overall Balance
of Payment (BoP) will always be in equilibrium. But, the system causes the national economy to
be vulnerable to external disturbances, including large amounts of capital flows and the amount
of exports and imports (Bank Indonesia, 2016). With the free floating exchange rate system
policy, The exchange rate of Rupiah is entirely determined by the market mechanism. Since
1997, the rate of Rupiah has sharply fluctuated, particularly since the financial crisis and the
floating currency. The exchange rate for Rupiah reached IDR14,900 per USD in June 1998. The
exchange rate re-established at the level of IDR13,000 per USD in July 1998 after it reached its
peak level. The Rupiah has been stabilized around IDR8,000 per USD since October 1999.
Back then, many economists felt that perfect economies should reach a market clearing
point and remain there. Market volatility could only result from incomplete or asymmetric
information barriers. Dornbusch rejected this opinion, arguing that volatility is actually much
more complex than that. Dornbusch (1976) shows that in a model where the exchange rate makes
adjustments faster than the price of goods, overshooting symptoms can occur. The price of
goods is inert and in the short term, as in the long term, is not fully adjusted. In exchange for
short-term exchange rates make adjustments more than they need in the long run. The
Dornbusch model's basic framework is the IS-LM model with a fixed price or hypothesis of a
fixed income. For example, current consumption and income do not adjust to the short-term as
much as it does in the long run, depending on current consumption on permanent income. This
forces the long-term response overshoot rate to permit expectations of the exchange rate.
The economic interaction between Indonesia and other countries has caused fluctuations
in the Rupiah exchange rate against foreign currencies. The exchange rate in the short term is
determined by a change in the estimate of the relative rate of return on domestic assets which
causes the demand curve to shift. Any factor that changes the estimate of the relative rate of
return on domestic assets will cause changes in exchange rates including the difference between
the money supply between money supply (M2) Indonesia and the United States, the GDP
difference between Indonesia's gross domestic income and the United States, differences
between Indonesia's and American benchmark interest rates, as well as the difference between
CPI between Indonesian CPI and the United States.
A study by Gregorius (2003) has concluded that using the overshooting model developed
by Dornbusch, it is proven that the increase in the money supply in the short term caused
Rupiah’s exchange rate to depreciate beyond its long-term depreciation value in 1998.
In the late 2018, The exchange rate of Rupiah against the United States Dollar along 2018
had surprised the public. The Rupiah even reached its weakest point to be above the level of
IDR15,200 per USD. This figure far exceeds the government's target in the 2018 State Budget
(APBN) of IDR 13,400 per USD. This condition is severe and alarming indeed, since the nominal
position of the currency is even worse than what happened in the 1998 crisis.
Explaining the Rupiah’s Depreciation in late 2018 using the Overshooting
Model
Before we can analyze this case using the overshooting model, these three assumptions must
hold true
In other words, the Investment Saving (IS) curve condition is determined by the quantity
of injections into the revenue stream and the competitiveness of the home country production
measured by the actual exchange level. The first hypothesis is fundamentally saying that the
position of the IS curve (demand for products) depends on the actual efficient exchange rate Q in
some manner.
If economic markets can change instantly and shareholders are risk-neutral, the exposed
price parity (UIP) holds at all moments can be said to hold. That is, the equation r = r* + Δe
always maintains. It is therefore an evident that any present exchange rate gap is offset by an
anticipated depreciation / appreciation. If r > r*, the exchange rate (a unit of overseas currency's
national cost) is supposed to rise. That is, proportion to the overseas exchange, the national
currency depreciates.
Dornbusch develops a sticky price model; it is based on the fact that labor market rates
for products and salaries are established in economies with "stiff rates" and tend to alter
progressively over moment in response to multiple shocks such as modifications in the change
of money supply. This overshooting model from Dornbusch offers significant additions to the
concept of exchange rates and the concept of exchange rate conduct. In this model we
concentrate on tiny nations facing a given world interest rate.
What happened in 2018 was at some sort curious. There is no expansionary monetary
policy in Indonesia, which caused the interest rate to go down—leaving the foreign investor with
no choice but to leave the country.This time, The Fed gradually raised their rate from 1,75% in
the mid 2018 to 2,5% in the late 2018—Bank Indonesia have no choice but to raise its rate too
from 4,25% in the mid 2018 to 6% in the late 2018. But, the capital are still flowing out of this
country—which is pretty much the same situation happened in the year before the previous
general election in 2014, when the capital are unstoppably flowing out of this country until the
end of the year so the investor could wait and see the potential candidates, yet it is followed by a
huge capital inflow in the next year. The same thing probably happened in the late 2018——
except that what happened was the markets have went on being strange for some time, and most
investors are confused about whether to sell, or buy, or panic, or just go to cash and avoid the
craziness, there was a lot of uncertainty in regards of the global economy related to the trade
war, let alone the political uncertainty in Indonesia a few month before the general election
happened.
The depreciation with an expected future appreciation implied that the overshooting
effect had started showing itself off. In the short run, due to the fact that prices are sticky, the real
2660000
2630000
2600000
Q2 2018 Q3 2018 Q4 2018 Q1 2019
Then, there would be some adjustment towards the long run. The excess in aggregate
demand pushes up prices, causing inflation. This would cause the real money supply to decrease
so the LM shift back to the initial equilibrium. The rise in prices, together with the currency
appreciation reduces the competitive advantages, so real exchangerate would go back to the
initial level, except that in this new equilibrium the price, and the exchange rate is now higher
Nowaday, Rupiah has reached its new equilibrium, the general election has passed, and capitals
are flowing in. But policymakers still need to maintain the internal and external balance, the
policy implications for managing the exchange rate are considered crucial. Capital inflow
management should be done by considering the use of interest rate instrument and
macroprudential to mitigate the risk of foreign capital flow suddenly and reversal, because
Rupiah's movement's is influenced by external factors, especially by the world’s geopolitical
situation. Therefore, by maintaining a low risk level on the domestic investment, capital inflows
should continue to increase.
Bahmani-Oskooee, M., & Panthamit, N. (2006). Exchange rate overshooting in East Asian
Bjørnland, H. C. (2009). Monetary policy and exchange rate overshooting: Dornbusch was right
Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of political Economy,
84(6), 1161-1176.
Warjiyo, P. (2013). Indonesia: stabilizing the exchange rate along its fundamental. BIS Paper,
(73m).