Abstract

This study estimates the exchange rate pass-through into domestic prices in Indonesia in the two-stage approach. The study focuses on first step pass-through, i.e. ERPT into import prices and second step pass-through, i.e. into consumer prices, using cointegration and error-correction mechanism (ECM) model. This research uses a Zivot-Andrews technique to test for structural breaks and Gregory-Hansen models to tests. The results show that the long run ERPT to import prices with structural breaks is relatively low compared to the results without them. The absolut error correction term values resulted from cointegration are decreased and the error-correction models need period lagged longer than one-period if the estimation included the estimated structural breaks. The main finding is that allowing for possible breaks around the crises in Indonesia, and a shift of the exchange rate management from managed to free floating in 1997 helps to restore a long run cointegration relationship estimation.

Highlights

  • In a small open economy model, openness has an impact on the domestic economy of a country through trade and capital flows from overseas

  • The countries’ openness in the international trade can be closely related to their exchange rate and prices. Both these variables can have effects on broader aspects relating to the welfare. These effects can be triggered by ERPT into domestic prices, especially those of imports

  • This study aims to examine empirically the ERPT into domestic prices in Indonesia and the speed of its adjustment by the estimated cointegration model and error correction mechanism (ECM)

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Summary

Introduction

In a small open economy model, openness has an impact on the domestic economy of a country through trade and capital flows from overseas. The countries’ openness in the international trade can be closely related to their exchange rate and prices. Both these variables can have effects on broader aspects relating to the welfare. These effects can be triggered by ERPT into domestic prices, especially those of imports. According to Kreinin (2002), ERPT is one of important factors in determining the response of trade balance besides the J-Curve effect and hysteresis, which contributes to a delayed response from the balance of trade against the dollar depreciation

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