Monetary policy responses on exchange rate dynamics: application to indonesia

Excessive fluctuation of exchange rate has negative impact on domestic economy as uncertainty rises. High fluctuations of the exchange rates also make domestic prices, interest rates and other macroeconomic variables more volatile as well. If exchange-rate volatility is persistent, there should be a systematic and measured policy to mitigate the foreign exchange fluctuations and to minimize the fluctuations as well as to drive it to its fundamental value. This dissertation involves four main parts to be investigated. The first part measures the persistence of exchange rate volatility in Indonesia. Therefore, in this research, the appropriate tool is needed to measure how persistent the exchange rate fluctuation in Indonesia thus the central banks are able to perform appropriate monetary policy especially in determining their policy interest rate or implementing foreign exchange intervention to stabilize the exchange rate. To model the fluctuation/volatility of USD/IDR, TGARCH approach is implemented. The central bank‘s response with foreign-exchange intervention is also investigated within this model. The results reveal that, USD/IDR volatility in Indonesia is persistent. Meanwhile, foreign-exchange sale intervention by Bank Indonesia has positive impact on USD/IDR return which can be interpreted as, an increase in foreign-exchange sale intervention causes Indonesian Rupiah Return to increase. However, Bank Indonesia‘s efforts to exert a stabilizing effect of foreign exchange interventions, the results do not gain a success. In the second part, this study elaborates the behavior of exchange rate expectation in the perspective of foreign-exchange trader‘s rules (i.e. fundamentalist and chartist). To see the impact of foreign exchange intervention to exchange rate expectation by the heterogeneous market trader, regime switching model is used. Therefore, this dissertation contributes to the noise trading channel by allowing foreign exchange intervention to influence the exchange rate expectation both forecasting rules of chartists and fundamentalists. In fact, this dissertation supports both chartists and fundamentalist regimes. It is shown that the two regimes are persistent significantly. Meanwhile, Bank Indonesia‘s foreign-exchange intervention has been able to drive the USD/IDR to its long-run fundamental ‗UIP‘ value within fundamentalist rule. However, Bank Indonesia efforts to exert a stabilizing effect of foreign-exchange interventions, the result does not show a success as its conditional variance has been increased. This finding may be caused by several external factors such as global financial shocks which could not be controlled by Bank Indonesia or caused by speculative transactions,‗disorderly markets‘ i.e. high fluctuation that may halt the effectiveness of foreign-exchange intervention operations. In the third part, this dissertation investigates the monetary responses to exchange rate dynamics. The deviation of exchange rate from the fundamental ‗desired‘ value would push the central bank to adjust its policy interest rate. To investigate whether the policy rate has been adjusted in responding to the exchange rate dynamics, a Structural Vector Auto Regression (S-VAR) and Generalized Method of Moments (GMM) approachs are applied. By implementing the methods in Indonesia, this dissertation finds that exchange rate dynamics of USD/IDR shock has ambiguous effect on policy interest rate reflected by overnight inter-bank rate fluctuations in the short run. Meanwhile, in the long run, the increase (decrease) of real USD/IDR exchange rate will push the central bank to raise (decrease) policy interest rate slightly (reflected by increased (decreased) domestic real o/n interbank interest rate) in order to halt further exchange-rate depreciation (appreciation) though it is not significant. In the final part, the governance aspect of foreign exchange interventions by Bank Indonesia will be elaborated. Several main issue regarding governance implementation in exchange rate intervention policy such as to whom or which authority that has powers to formulate objectives and to implement exchange-rate policy. Another important aspect concerns on how decision-making process on interventions applied at the operational level. In this part, information on governance arrangements guiding foreign exchange interventions, on Bank Indonesia related communications policies, and on the accountability of central banks for their intervention decisions, is provided. As USD/IDR exchange rate volatility is driven by various factors, relying solely on Bank Indonesia‘s FX intervention and interest rate policy to mitigate foreign-exchange volatility and misalignment, is not always sufficient. By combining with other policies called ‗policy mix‘ and implementing governance principles, the stability of the exchange-rate is hopefully achieved effectively. Furthermore, beyond of that the foreign-exchange intervention combined with other policies should also be consistent with achieving the inflation target and supporting sustainable domestic economic growth. Keywords: ARCH/GARCH, governance, foreign-exchange intervention, monetary policy, exchange rates, regime-switching