ANALYSIS OF CAUSALITY BETWEEN EXCHANGE RATE AND INFLATION IN THE PURCHASING POWER PARITY THEORY IN INDONESIA IN 1997 - 2019

Abstract

Indonesia have joined international trade in the world, so exchange rate and inflation become important enough in economic. This study aims to determine the long-term balancing and casuality relationship between exchange rate and inflation in Indonesia in 1997-2019. This study uses time series data from 1997-2019, data sourced from World Bank. In this study, data analysis using Vector Autoregression (VAR) method. The analysis shows that based on cointegration test results, Exchange rate has a balanced movement in the long term although it has fluctuated in the short term, and so does inflation. Meanwhile, based on Granger’s causality test results, it shows that exchange rate has a significant effect for inflation. In addition, inflation has a significant effect for exchange rate. The existence of giving impact for each other between exchange rate and inflation in Indonesia during 23 year’s period (1997-2019), it can be stated that there’s a casuality relationship where changes of exchange rate can give effect for inflation in Indonesia or in the otherwise such a theory of purchasing power parity which explains that there’s a relationship in two-way between exchange rate and inflation in a country. Based on the findings, the policy implications that can be taken are relevancy to maintain the stability of exchange rate and inflation in Indonesia by the Government and Bank Indonesia as the monetary authority.