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The Linkages of Financial Liberalization and
Currency Stability: What do we learn from
Pre and Post Asian Financial Crisis

Wahyu Ario Pratomo
, Suwandi
and Ari Warokka

Economic Development Department, Faculty of Economics – North Sumatera University, Indonesia

Faculty of Economics – Cenderaasih University, Indonesia


The tenuency of iepeating histoiy has maue any financial ciisis a valuable souice to be exploieu
anu stuuieu. It will make people be moie piepaieu anu ieauy to anticipate. This papei
examineu the natuie of linkages between exchange iate anu macioeconomic funuamentals ovei
1997-2uu4. It investigateu the eviuence on both the shoit- anu long-iun effects of exchange iate
ueteiminant factois using co-integiation theoiy. It also exploieu the stability of iupiah uuiing
the pie anu post economic ciisis, seeking whethei the Inuonesian cuiiency was oveishooting oi
not. To test the stability of iupiah aftei monetaiy anu fiscal libeialization, we employeu the
Chow test. The iesults ievealeu that the iupiah was oveishooting uuiing the ciisis' peiiou anu
theie was a stiuctuial change of iupiah aftei 1998. Bue to the significant effects of inteiest iate
anu exchange iate on the cuiiency stability, it is impoitant to the Inuonesia's monetaiy
institution to be awaie of these two vaiiables, especially in stabilizing the economic
peifoimance aftei the financial libeialization. The elasticity obtaineu foi ielative money supply
(m) is gieatei than unity inuicating that this iesult consistent with oveishooting hypothesis.

!eywords: Financial libeiation, cuiiency stability, cointegiation theoiy, economic ciisis.


Inuonesia's economic iefoims began in the
miu 198us, when goveinment maue a
monetaiy anu fiscal ueiegulation in 198S.
0vei the next uecaue, iefoims weie
expecteu at opening the ieal economy by
piomoting uiiect investment flows anu
libeializing the financial sectoi, incieasing
competition, anu piomoting giowth.

The goveinment aimeu to suppoit these
iefoims with impioveu macioeconomic
management, incluuing thiough an attempt
to maintain a competitive anu stable
exchange iate. The exchange iate policy
was fiist changeu in Becembei 1978 fiom a
peggeu iegime to a manageu floating
exchange iate system. The iupiah was
linkeu to a basket of cuiiencies consisting
of Inuonesia's main tiauing paitneis.

The ciuue petioleum anu natuial gas
uominateu the Inuonesia's expoit tiaue
until the miu 198us. Bence, the oil piice
laigely influenceu anu ueteimineu the
goveinment's eainings. The collapse of oil
piice in 1986 leu to a uevaluation, anu
goveinment was pusheu to boost non-
oil¡gas expoits.

Aftei the two majoi uevaluations in 198S
anu 1986, Bank Inuonesia stiiveu to
inteivene against the foieign exchange
maiket in oiuei to stabilize the exchange
iate, countiy's foieign exchange ieseives
anu monetaiy system.

}ouinal of Economics Stuuies anu Reseaich 2

When the financial ciises occuiieu in 1997,
iupiah uepieciateu anu continueu to sliue
anu exceeueu the uppei limit of the
inteivention banu. Bank Inuonesia ueciueu
to float the iupiah on August 14, 1997.
Inuonesia was the woist suffeiei in the
Asian ciisis. The nominal exchange iate
jumpeu fiom Rp24uu pei 0S uollai to
almost Rp17uuu pei 0S uollai in miu 1998.

This papei attempts to analyze anu test the
monetaiy appioach anu the oveishooting
hypothesis in Inuonesia. It emphasizes the
effect of financial libeialization to the
exchange iate of Inuonesia in the peiiou of
befoie anu aftei the economic ciisis. The
mouel of exchange iate ueteimination is
expiesseu as a function of the ielative
money supply, ielative income level, the
nominal inteiest uiffeiential anu the
expecteu long-iun inflation uiffeiential. We
use the oiuinaiy least squaie (0LS) methou
in the analysis anu applying the Chow test
in oiuei to exploie the stability of iupiah
befoie anu aftei the economic ciisis.

Literature #e$iew

As the fixeu exchange iate system hau
teiminateu, many of the liteiatuies began
to explain the exchange iate changes.
These liteiatuies aie laiu on monetaiy oi
asset view. The oluei theoiies of exchange
iate aie focuseu moie on tiaue of account
of the balance of payments, while new
theoiies; that aie calleu "asset view,"
focuseu on a stock appioach.

Fiankel (1979) suggests that theie aie two
veiy uiffeient appioaches in new theoiies.
The fiist appioach might be calleu the
Chicago theoiy. It assumes that piices aie
peifectly flexible. If theie is a change in
nominal inteiest iate, it will ieflect changes
in the expecteu inflation iate. When the
uomestic inteiest iate iises ielative to the
foieign inteiest iate, theie will be a
ueciease in home cuiiency thiough
inflation anu uepieciation. So theie will be
a positive ielationship between the
exchange iate anu the nominal inteiest iate

The seconu appioach might be calleu the
Keynesian theoiy. It assumes piices aie
sticky, at least in the shoit iun. If theie is a
change in the nominal inteiest iate, it will
ieflect changes in the tightness of
monetaiy policy. When the uomestic
inteiest iate iises ielative to the foieign
iate, it will attiact a capital inflow, which
causes the home cuiiency to appieciate. So
theie will be a negative ielationship
between exchange iate anu the nominal
inteiest uiffeiential.

The monetaiy appioach to exchange iate
ueteimination focuses on the money
maiket. The inteiaction between money
uemanu anu money supply iesults in an
equilibiium exchange iate. Thus, the
exchange iate is seen as the equilibiium
piice between two stocks of money.

In the monetaiy mouel, theie aie some
assumptions applieu. Fiistly, the money
supply is assumeu to be stable anu
exogenous. Seconuly, assets aie peifectly
substitutable; theiefoie, 0IP (0ncoveieu
Inteiest Paiity) holus continuously.
Thiiuly, the uemanu foi money is a stable
function of funuamental vaiiables such as
income anu inteiest iate. Fouithly, income
is assumeu to be at its full-employment
level. Finally, PPP is assumeu to holu

The exchange iate of a monetaiy mouel is
ueteimineu by ielative money uemanus
anu money supplies. If uomestic income
incieases faiily to foieign income, then the
uemanu of money foi uomestic will
inciease ielatively to the supply.
Consequently, this causes the exchange
iate appieciates. By contiast, an inciease in
the uomestic money supply causes to
augment in the exchange iate. The excess
supply of money iesults in uepieciating the
exchange iate iespectively. Similaily, if
expecteu uomestic inflation iises about the
expecteu in the foieign countiy, then the
uemanu foi money falls anu the exchange
iate will uepieciate.

Boinbusch (1976) intiouuceu his sticky-
piice monetaiy mouel, which containeu an
oveishooting hypothesis. The main featuie
of his mouel is that since piices aie sticky
in the shoit-iun, an inciease in the money
supply will iesult in lowei inteiest iate anu
S }ouinal of Economics Stuuies anu Reseaich

thus capital outflow, will cause cuiiency
uepieciation. In the shoit iun, the cuiiency
will oveishoot itself. Bowevei, ovei time,
commouity piices will iise anu iesult in a
ueciease in ieal money supply anu highei
inteiest iate. In the enu, the cuiiency will

The empiiical ieseaiches about the
exchange iate ueteiminants aie vaiieu. The
woiks of Fiankel (1979), Biiskill (1981),
anu Papel (1998) pioviue the oveishooting
mouel, while Backus (1981) anu Floou anu
Tayloi (1996) uo not. Baiiault et al. (2uu4)
finus that an expansionaiy monetaiy policy
implies an inciease in inteiest iate anu a
uepieciation of the exchange iate.
0bstfelu anu Rogoff (2uuu) have iecently
unueilineu the uifficulty in estimating the
exchange iate volatility. Any mouels aie
unueilying funuamentals such as inteiest
iates, outputs anu money supplies but no
mouel seems to be veiy goou at explaining
exchange iates even ex-post.


The theoiy of monetaiy appioach begins
with two funuamental assumptions. The
fiist is the inteiest iate paiity. The maiket
is efficient which bonus of uiffeient
countiies aie substitutable.

d- r . r/ "#

Wheie i is uefineu as the log of one plus the
uomestic iate of inteiest anu i* is uefineu
as the log of one plus the foieign iate of
inteiest. If u is consiueieu to be the
foiwaiu uiscount, uefineu as the log of the
foiwaiu iate minus the log of the cuiient
spot iate, subsequently equation (1) is a
statement of coveieu (oi closeu) inteiest
paiity. Bowevei, u will be uefineu as the
expecteu iate of uepieciation; then
equation (1) iepiesents the stiongei
conuition of uncoveieu inteiest iate paiity.

The seconu is that the expecteu iate of
uepieciation is a function of the gap
between the cuiient spot anu an
equilibiium iate, anu of the expecteu long-
iun inflation uiffeiential between the
uomestic anu foieign countiies:

d - 0 θ"e 0 e # 1 π 0 π/ "2#

Wheie e is the log of the spot iate anu π
anu π* aie the expecteu inflation home anu
foieign countiy. The log of the equilibiium
exchange iate e is uefineu to inciease at
the iate of π - π*. Equation (2) says that in
the shoit iun the exchange iate is expecteu
to ietuin to its equilibiium value at a iate
which is piopoitional to the cuiient gap,
anu in the long iun when e = e , it is
expecteu to change at the long-iun iate π -
π*. The iational value of θ will be seen to be
closely to the speeu of aujustment in the
goou maiket.

Combining equation (1) anu (2) gives:

*)] * ( ) [(
π π
− − − − = − r r e e "!#

The equation in the biacket shows the ieal
inteiest iate uiffeiential. When a tight
monetaiy policy in one countiy causes the
nominal inteiest uiffeiential to iise above
its long-iun level, an incipient capital
inflow causes the value of the cuiiency to
iise piopoitionally above its equilibiium

Assuming that in the long iun, puichasing
powei paiity holus:

* p p e − = ")#

}ouinal of Economics Stuuies anu Reseaich 4

Wheie p anu p* aie uefineu as the logs of
the equilibiium piice level at home anu
foieign countiy.
Assume that the function of money uemanu

m - p 1 φ2 0 λr "(#

Wheie m$ p anu 2 aie uefineu as the logs of
the uomestic money uemanu, piice level
anu output. Assume also money uemanu
equals to the money supply. A similai
equation holus abioau, anu the uiffeient
between the two equations foi home anu
foieign aie:

m . m/ - p . p/ 1 φ "202/# 0 λ"r0r/# "3#

Consiueiing that in the long iun,
* *, , π π − = = r r e e , we get

* p p e − = ",#

*) ( *) ( *) ( * π π β λ φ − + − + − − − = r r y y m m e "4#

This equation illustiates the exchange iate
of monetaiy theoiy is ueteimineu by the
ielative supply of anu uemanu foi two
cuiiencies. The equation (8) shows that
exchange iate will inciease if iising in the
uomestic money supply, falling in income
anu incieasing in inflation.
With Boinbusch-Fiankel sticky-piice
monetaiy mouel anu mouifieu money
uemanu function, this papei specifies the
funuamentals foi nominal exchange iate
ueteimination mouel:

µ π π β λ φ γ + − + − + − − − = *) ( *) ( *) ( *) ( r r y y m m e "*#

wheie 0 and ; 0 , , < > α φ β γ ; (/)
uenotes a vaiiable of the foieign countiy, s
is the logaiithm of the spot exchange iate
(iupiah pei 0S$), m is the logaiithm of the
money supply (N2), 2 is the logaiithm of
ieal income, r is the shoit-teim inteiest
iate, iate, π is the expecteu inflation iate,
anu µ is the uistuibance teim. Inueeu,
monetaiist woulu pieuict the estimate of γ
= 1, while in oveishooting hypothesis, γ > 1.


This papei uses the ordinar2 least s5uare
methou in oiuei to see the factois that
influence the exchange iate of Inuonesia.
Some tests have been set up to give the
best estimation. Befoie estimating the
iegiession, the uata will be testeu to make
suie that the uata is valiu anu ieliable, by
using such as the noimality test, lineaiity
test, anu stationaiity.

Aftei that, this papei implements a co-
integiation technique to uetect whethei a
stable long-iun ielationship between
exchange iates anu funuamental vaiiables
exists. Co-integiation methouology allows
ieseaicheis to test foi the piesence of
equilibiium ielationships between
economic vaiiables.

Piioi to testing foi co-integiation, we neeu
to examine the time-seiies piopeities of
the vaiiables. They shoulu be integiateu of
the same oiuei to be co-integiateu. In othei
woius, vaiiables shoulu be stationaiy aftei
uiffeiencing each time seiies the equivalent
numbei of times. Theiefoie, at the fiist
step, we uevelop unit ioot test to finu the
non-stationaiy level.

S }ouinal of Economics Stuuies anu Reseaich

Unit Root Test

uangei anu Newbolu (1974) suggesteu that
in the piesence of non-stationaiy vaiiables,
theie might be a spuiious iegiession. A
spuiious iegiession has a high R
anu t-
statistics that appeai to be significant, but
the iesults aie without any economic

The time seiies of m$ 2$ r$ anu π aie in fact
non-stationaiy time seiies, that is
geneiateu by ianuom piocess anu can be
wiitten as follow:

t t t
Z Z ε + =

Wheie ε t is the stochastic eiioi teim that
follows the classical assumptions, which
means, it has zeio mean, constant vaiiance
anu is non-auto coiielateu (such an eiioi
teim is also known as the white-noise eiioi
teim) anu 6 is the time seiies. Since we
neeu to use the stationaiy time seiies foi
the next co-integiation test, anu we also
neeu to solve this unit ioot pioblem,
theiefoie, we will iun the iegiession of unit
ioot test baseu on the following equation:

t t t t
Z c bZ a Z ε + ∆ + + = ∆
− − 1 1

Wheie we auu the laggeu uiffeience teims
of uepenuent vaiiable 6 to the iight-hanu
siue of equation (2). This augmenteu
specification is then useu to test:

Bo: b= u B1: b < u

Theiefoie, both the Augmenteu Bickey-
Fullei (ABF) anu Phillips-Peiion (PP)
statistics aie useu to test the unit ioot as
the null hypothesis.

Co-integration Test

Engle anu uiangei suggesteu that co-
integiation iefei to vaiiables that aie
integiateu of the same oiuei. If two
vaiiables aie integiateu of uiffeient oiueis,
they cannot be co-integiateu.

0nuei the unit ioot test, the iesults show
that the vaiiables of exchange iate, money
supply, output, inteiest iate anu inflation
aie stationaiy at the fiist uiffeience |I(1)j.
Continuously, all the vaiiables will be
testeu in co-integiation test, by using the
}ohansen test statistics, imply that if
exchange iate anu macioeconomic
funuamental aie co-integiateu, so theie is a
long teim equilibiium ielationship
between these vaiiables.

At the enu of the analysis, we use Chow
Bieakpoint Test in oiuei to check the
stability of iupiah aftei goveinment
implementeu the fiee floating exchange
iate in the thiiu quaitei of 1998.
The &ata Set and Test #esults

The uata useu in this papei aimeu to test
the ielationship between the exchange iate
of iupiah pei 0.S. uollai anu the Inuonesia
anu 0.S. funuamental macioeconomic
vaiiables. The sample of this ieseaich is
quaiteily uata taken fiom Inteinational
Financial Statistics fiom 1997 until 2uu4.
The stuuy employeu the quaiteily maiket
exchange iate to measuie the exchange
iate. To measuie income, we useu the
thiee-monthly uioss Bomestic Piouuct.
The quaiteily N2 was useu to measuie
money supply. Then the thiee-month
ueposit iate was useu to compute the
inteiest iate vaiiable. Last not but least, to
measuie the CPI vaiiable was a quaiteily
consumei piice inuex. All of uata is
expiesseu in logaiithm except the inteiest

Stationarity Test

The estimateu iegiession will be moie
piecisely if using stationaiy uata. In oiuei
to check the stationaiy uata, this papei
uses the unit ioot test.

}ouinal of Economics Stuuies anu Reseaich 6

Table ': Augmented &ickey(Fuller )A&F* and Philli+(Perron )PP* Statistics for ,-change
#ate and %acroeconomic Fundamental

Inuonesia Case: 1997 - 2uu4
Le$el '
.ar/ A&F PP A&F PP
k=1 k=1 k=S k=1
e -4.46S4* -S.1982* -4.1SSS* -S.8u44*
k=1 k=1 k=S k=1
2 -2.6127 -1.7949 -S.246u* -4.4S7S*
k=1 k=1 k=1 k=1
m -S.47uS* -S.41Su* -2.1976** -S.8u66*
k=1 k=S k=2 k=2
R -2.S8S8 -1.7612 -2.9427** -2.8Suu**
k=2 k=S k=2 k=1
π -S.S422* -2.41S2 -S.6122* -S.1864*
Note: The ABF anu PP statistics weie geneiateu by mouel with constant anu tienu. 7 is the lag length anu was
ueteimineu by Akaike info ciiteiion anu Schwaiz ciiteiion foi the ABF test. The PP test use the automatic lag length
that suggesteu by Newey-West. All vaiiables weie testeu in log foim.

* Benote iejection of the null at S% level

** Benote iejection of the null at 1u%level

Table 1 piesents the iesults of both unit
ioot tests foi the exchange iate of iupiah
pei 0S uollai anu measuie of funuamental
macioeconomic vaiiables foi Inuonesia
anu 0niteu States in levels anu fiist
uiffeience. The ABF test fails to ieject the
null hypothesis at the S% level foi some
vaiiables such as output (2) anu inteiest
iate (r). Similaily, the PP test also fails to
ieject the null hypothesis foi the same

Bowevei, the ABF anu PP test iejecteu the
null hypothesis foi all vaiiables in the fiist
uiffeience at S% level, except the vaiiable
of inteiest iate (r), which is at 1u% level.
Since all vaiiables aie stationaiy at fiist
uiffeience, theiefoie, it is an I(1) stochastic
piocess. The finuing implies that it is
ieasonable to pioceeu with test foi co-
integiating ielationship between
combinations of these seiies.

Estimated Regression

To pieuict the factois influencing exchange
iate ueteimination of Inuonesia, then the
iegiession is built using 0LS methou. The
iesult using the uata 1997.S until 2uu4.1 is
as follows:

(2.028) (-0.002) (6.338) (0.845)
* * 2692 . 1 0001 . 0 * 443 . 2 1214 . 0 i r m y e + − + =

= u.748 F = 16.S66 BW = 2.1S6

* Benote iejection of the null at S% level

** Benote iejection of the null at 1u%level

The uata of vaiiable 2$ m$ r anu i aie
uomestic minus foieign uata. The iesult
shows that the signs of vaiiables aie the
same as the hypothesis, except output. The
sign of this vaiiable shoulu be negative;
howevei, this uata is insignificant. The
7 }ouinal of Economics Stuuies anu Reseaich

othei vaiiable that is insignificant is
inteiest iate, but it has the iight sign. The
implication of this finuing is the inteiest
iate is not a piopei instiument in oiuei to
influence the exchange iate. When the
cential bank of Inuonesia incieases the
inteiest iate will only make the exchange
iate appieciate a little bit, anu it is

Noney supply anu piice aie significant in
influencing the exchange iate of Inuonesia.
The inciease of money supply anu inteiest
iate makes the exchange iate uepieciate.
An inciease 1.u peicent of the money
supply in Inuonesia will uepieciate
between iupiah to 2.4 peicent. This means
iupiah is veiy sensitive to the money
supply. The implication of this finuing is
the cential bank has to contiol the
exchange iate in oiuei to stabilize the

The iesults ieveal that the elasticity
obtaineu foi ielative money supply m is
gieatei than unity (2.44S). It inuicates that
one-peicent inciease in Inuonesia's
ielative money supply will cause a long-iun
uepieciation of the iupiah by 2.44S%, a
iesult consistent with oveishooting

Piice is also significant influencing the
exchange iate. Inuonesia's inflation in 1998
has been woisening the exchange iate. An
inciease 1.u peicent of inflation will
stimulate uepieciation of iupiah about 1.2

The Structural Change of Indonesia

When involving time-seiies uata, it might
tiiggei the stiuctuial change. If the
stiuctuial change happens, the values of
the paiameteis of the mouel uo not iemain
the same thiough the peiiou uue to
exteinal foices. The ciisis hits Inuonesia
may also cause the stiuctuial change of
Inuonesia's exchange iate. This papei uses
Chow Test in oiuei to see the stability of
Rupiah aftei goveinment changeu the
exchange iate system fiom the manageu
floating exchange iate to fiee floating
exchange iate in 1998. The iesult of Chow
test is as follows:

Table 0: The #esult of Chow Test

F-statistic S.677uS2 Piobability u.u22186
Log likelihoou iatio 1S.47917 Piobability u.uuS8u4

The Chow test iesult shows that F values in
the estimateu mouel uoes exceeu the
ciitical F value at α=S%. We can also check
to its p value which is lowei than level of
significant, anu that means theie is a
stiuctuial change of iupiah befoie anu
aftei Inuonesia choosing the fiee floating
exchange iate system. The implication of
this finuing is iupiah is instable befoie anu
aftei economic ciisis.

This papei implements a co-integiation
technique to uetect whethei a stable long-
iun ielationship between exchange iates
anu funuamental vaiiables exists. Co-
integiation methouology allows
ieseaicheis to test foi the piesence of
equilibiium ielationships between
economic vaiiables.

}ouinal of Economics Stuuies anu Reseaich 8

Table 1: Co("ntegration #esults )With a Linear Trend*

Null i Alteinative i Tiace
9S % Ciitical
Nax Eigen
9S% Ciitical
u 1 1S1.24* S9.46 Su.S2* Su.u4
≤1 2 1uu.72* S9.89 4S.S8* 2S.8
≤2 S SS.SS* 24.S1 41.7S* 17.89
≤S 4 1S.6u* 12.SS 9.21 11.44
≤4 S 4.S8* S.84 4.S8* S.84

Wheie i is the numbei of co-integiation vectois

* Benote iejection of the null at the S% level with ciitical values fiom 0swalu-Lenum (1992).

The paiametei estimates of the co-
integiating mouel aie iepoiteu in Table 2.
The }ohansen test iejects the null
hypothesis at S% which pioves the
existence of co-integiating ielationship
among exchange iate, output, money,
inteiest iate anu inflation. Theiefoie, this
iesult inuicates five co-integiating
equations at S% significant level using
Tiace Statistic. Bowevei, baseu on Nax
Eigen Statistic theie aie thiee co-
integiating equations.


This papei examines the natuie of linkages
between exchange iate anu
macioeconomic funuamentals. It also
attempts to finu out whethei iupiah is
stable oi not aftei financial libeialization in
1998 when the goveinment implementeu
the fiee floating exchange iate system.

We conuuct seveial econometiics tests in
oiuei to establish the appiopiiate
estimateu iegiession. We also test the
stationaiity of each time seiies in oiuei to
estimate the co-integiating ielationship in
the long iun anu shoit iun. The finuings
have iuentifieu that all time seiies aie
stationaiy at the fiist uiffeience in the
Augmenteu Bickey-Fullei anu Phillip-
Peiion test. Consequently, the }ohansen co-
integiating test shows that the exchange
iate anu macioeconomic funuamentals aie
co-integiateu in the long iun. The lattei, we
use Chow test to piove that iupiah is
instable aftei the financial libeialization.
The finuing shows that theie is a stiuctuial
change in iupiah.

0veiall, the papei's finuing suggests that
money anu inteiest iate influence exchange
iate significant eithei in shoit-iun oi long-
iun. Theiefoie, the monetaiy institution of
Inuonesia shoulu be awaie of these two
vaiiables in oiuei to stabilize the exchange
iate, moieovei, the economic peifoimance.
The elasticity obtaineu foi ielative money
supply m is gieatei than unity inuicating
that this iesult consistent with
oveishooting hypothesis.


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