The Sources of Indonesia’s Current Account Balance Fluctuations: An Empirical Test of the Vector Error Correction Model (VECM)

Abstract

Identifying the sources of current account balance fluctuations is critical to formulating Indonesia’s macroeconomic policies which maintain both internal and external balance to guarantee sustainable economic development as mandated by The Central Bank of Indonesia Act. This study is an attempt to investigate the long-run relationship between the current account balance (including total trade balance and non-oil and gas trade balance), world exports, domestic income (a proxy by industrial production index), and real effective exchange rate in the case of Indonesia’s economy. Based on the traditional approach of elasticity (Marshall Lerner condition) and by applying the VECM method to monthly data for the period January of 2008 up to December 2012, the investigation to examine the existence of a long-run equilibrium relationship between the current account balance and its sources is conducted. Additionally, variance decompositions (VDCs) and impulse response functions (IRFs) are used to draw further inferences. The result of the VECM method indicates that there is a stable long-run relationship between the current account balance and real effective exchange rate, domestic income and world exports variables. The estimated results show that real effective exchange rate depreciation is positively related to the current account balance in the long run, consistent with the Marshall Lerner condition. This study also finds evidence of the J-curve on Indonesia's current account balance. This suggests that following a real effective exchange rate depreciation, the Indonesia current account balance will initially deteriorate but improve in the long-run. Thus the exchange rate policy can help improve the current account balance. Furthermore, the results provide strong evidence that world exports and domestic income play a strong role in determining the behavior of the current account balance.