Exchange Rates, Interest Rates, and Inflation Rates in

Journal of Transition Economics and Finance
ISSN 1986-4620 Issue 3 (2011)

EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/jtef.htm

Exchange Rates, Interest Rates, and Inflation Rates in
Indonesia: The International Fisher Effect Theory

Siti Rahmi Utami
Maastricht School of Management Endepolsdomein 150
6229 EP Maastricht, The Netherlands
E-mail: utami25@yahoo.com; siti_rahmiutami@yahoo.com

Eno L. Inanga
Maastricht School of Management Endepolsdomein 150
6229 EP Maastricht, The Netherlands
E-mail: inanga@msm.nl
Tel: +31 43 387 0808

Abstract

This paper tests and analyses the influence of interest rate differential on exchange
rate changes based on the International Fisher Effect theory and the influence of inflation
rate and interest rate differentials in Indonesia. To test this theory, we use quarterly and
yearly data for the interest rates, inflation rate differentials, and changes in exchange rates
over a five-year period, 2003-2008. We chosen for our study four foreign countries,
namely, the USA, Japan, Singapore, and the UK, based on their levels of economic
development and industrialization, and Indonesia as the home country. Regression results
show that interest rate differentials have positive but no significant influence on changes in
exchange rate for the USA, Singapore, and the UK relative to that of Indonesian. On the
other hand, interest rate differentials have negative significant influence on changes in
exchange rates for Japan. Regression results also show that, overall, inflation rate
differentials have positive significant influence on interest rate differential.

Keywords: International Fisher Effect Theory, Exchange Rates, Interest Rates, and
Inflation Rates.
JEL Classification Codes: E40, E43

1. Introduction
The International Fisher Effect (IFE) theory suggests that foreign currencies with relatively high
interest rates will tend to depreciate because the high nominal interest rates reflect expected rate of
inflation (Madura, 2000). This theory also proposes that changes in the spot exchange rate between two
countries will also tend to equate the differences in their nominal interest rates (Demirag and Goddard,
1994).
Exchange rate control could be very costly, and even become pointless, when speculators attack
a currency, in even under government protection. High interest rate will prevent capital outflows,
hinder economic growth and, consequently, hurt the economy (Solnik, 2000). Several factors could
cause exchange rate changes. These include changes in foreign exchange supply and demand, balance
Journal of Transition Economics and Finance - Issue 3 (2011) 30

of payments problems, rising inflation, interest rate, national income, monetary supervision, changing
expectations and speculation (Khalwaty, 2000).
In linking exchange rate changes with changes in interest and inflation rates, the International
Fisher Effect theory states that the future spot rate of exchange can be determined from nominal
interest differential. The differences in anticipated inflation that are embedded in the nominal interest
rates are expected to affect the future spot rate of exchange (Sundqvist, 2002). Therefore this study will
test and analyse the influence of interest rate differentials on change in exchange rates based on the IFE
theory and previous studies (Thomas, 1985 ; Sundqvist, 2002 ; and Hakkio, 1986), and the influence of
inflation rate on interest rate differential as studied by Miyagawa and Morita (2003), Jensen (2006),
Peng (1995), Mishkin (1984), Cooray (2002), and Crowder (2003).
In the process of doing so, we will also test the extent to which the IFE theory is applicable to
the Indonesian economy. Specifically, the study will attempt to answer the question, To what extent
does high nominal interest rate reflect high level of expected inflation in the Indonesian economy ?
Based on the IFE theory, if we combine inflation rate with interest rate, we should expect high interest
rate to result in a weaker currency.
To test the applicability of this theory to the Indonesian economy, we will use quarterly and
yearly data for the interest rate differentials, inflation rate differentials, and changes in exchange rates
over a 5-year period of 2003 to 2008. We have chosen as foreign countries the USA, Japan, Singapore,
and the UK based on their levels of economic development and industrialization. Indonesia is chosen
as the home country.
The rest of this paper is structured in 5 sections. Section 2 reviews relevant literature on the
International Fisher Effect theory, and highlights some of the empirical findings of other similar
studies. In section 3 we state the hypotheses based on these studies. Section 4 discusses the research
methodology and data used for the study. Sections 5 and 6 present the study results and conclusions
respectively.

2. Literature Review
The International Fisher Effect (IFE) theory explains the relationship between the interest rate
differentials of two countries and the expected exchange rate changes. The derivation of this
relationship according to the IFE is that the actual return to investors who invest in money market
securities in their home country are the foreign interest rate and the change in the foreign currency
value (Madura, 2000).
The formula of the actual return which also called effective (exchange rate adjusted) return is
( )( )
1 1 1
f f
r i e = + + , where r is the actual returns to investors, i
f
is the foreign interest rate, and e
f
is
the percentage change in the value of the foreign currency denominating the security (Madura, 2000).
The International Fisher Effect theory therefore suggests that the expected return on a foreign
money market investment, ( ) E r , should be equal to the interest rate on a local money market
investment,
h
i
, since on average, the effective return on a foreign investment should be equal to the
effective return on a domestic investment in equilibrium. Thereby ( ) E r is made equal to
h
i , ( )
h
E r i = .
In order to make investments in both home and foreign countries to yield similar returns, r is set
equal to i
h,
and the foreign currency must change to make
h
r i = . Therefore
( )( )
1 1 1
f f h
i e i + + = ,
where r is the effective return on the foreign deposit and i
h
is the interest rate on the home deposit. The
formula of i
h
is expressed as
( )( ) ( ) 1 1 1
f f h
i e i + + = + , and
( )
( )
( )
1
1
1
h
f
f
i
e
i
+
+ =
+
, to determine for the
foreign currency value (e
f
). Finally, the International Fisher Effect function would be formulated as:
31 Journal of Transition Economics and Finance - Issue 3 (2011)

( )
( )
1
1
1
h
f
f
i
e
i
+
=
+
(Model 1)
Hence, the IFE theory concludes that when home interest rate is higher than foreign interest
rate, the foreign currency value will be positive, since the relatively low foreign interest rate reflects
relatively low inflationary expectations in the foreign country. The foreign currency will then
appreciate, as the foreign interest rate will be lower than the domestic interest rate. This appreciation
would then increase the foreign returns to investors in the home country, thereby moving returns on
foreign securities close to returns on home securities. If, on the other hand, when home interest rate is
lower than foreign interest rate, the foreign currency value will be negative, because the foreign
currency will depreciate when the foreign interest rate exceeds the domestic interest rate. This
depreciation will tend to reduce the returns on foreign financial securities and make them unattractive
to domestic investors in the financial securities in the home country money market to yield higher
returns.
The IFE theory is the international counterpart of the Fisher Effect. It can be seen as a
combination of the generalized version of the Fisher Effect and the relative version of the Purchasing
Power Parity (Sundqvist, 2002). The generalized version of the Fisher Effect specifies a relationship
between interest rates differential of two countries and their inflation rates differential. Countries with
high rates of inflation should have higher nominal interest rates than countries with lower rates of
inflation.
Madura (2000) also aligns that the International Fisher Effect theory closely with the
Purchasing Power Parity (PPP) theory because of the often observed high correlation of interest rates
with inflation rates. The PPP theory suggests that the changes in exchange rate are caused by the
inflation rate differentials. While any difference in nominal interest rates would be attributable to the
difference in expected rates of inflation, the real interest rates are the same across countries, as Fisher
equation implies that the nominal interest rate is equal to the real interest rate plus the expected rate of
inflation. Meanwhile, the IFE theory suggests that relatively high interest rates of foreign currencies
will depreciate because high nominal interest rates tend to reflect expected inflation.
In order to demonstrate the relationship between relative inflation rates and exchange rates
according to the PPP, model 2 is expressed as follows:
( )
( )
1
1
1
h
f
f
I
e
I
+
=
+
(Model 2)
Model 2 indicates that when home inflation rate, I
h
, is higher than foreign inflation rate, I
f
, the
foreign currency value will be positive, implying that foreign currency will tend to appreciate when
domestic inflation rate exceeds the foreign inflation rate. Conversely, if home inflation rate is lower
than foreign inflation rate, the foreign currency value will be negative. This implies that the foreign
currency value will depreciate when the foreign countrys inflation rate exceeds that of the home
country.
Since the generalized version of the Fisher Effect specifies a relationship between interest rates
differential and inflation rates differential, we get :
( )
( )
( )
( )
1 1
1 1
1 1
h h
f f
i I
i I
+ +
=
+ +
(Model 3)
By combining model 1 and model 2, we have :
( )
( )
( )
( )
1 1
1 1
1 1
h h
f
f f
i I
e
i I
+ +
= =
+ +
(Model 4)

The value of the foreign currency, e
f,
will be formulated as
1 t t
t
S S
S
+

to determine the change in
its value. Therefore, model 4 and 5 are expressed to show how the exchange rate change, interest rate,
and inflation rate differentials are related :
( )
( )
( )
( )
, , , ,
1
, ,
1 1
h t f t h t f t
t t
t f t f t
i i I I
S S
S i I
+

= =
+ +
(Model 5)
1

Where
1 t
S
+
is the spot exchange rate at time t+1,
t
S is the domestic currency value of one unit
of foreign currency at time t,
, h t
i is interest rate at time t in the home country,
, f t
i is interest rate at time
t in the foreign country,
, h t
I is inflation rate at time t in the home country,
, f t
I is inflation rate at time t
in the foreign country.
Recently there have been many studies of the International Fisher Effect and the Fisher Effect
theories, such as the research by Crowder (2003), who used data from several sources for his studies.
These sources included the OECD Main Economic Indicators, monthly observations on short-term
nominal interest rates and CPI inflation data. The study focused on eight industrialized countries and
covered a period of over three decades from January 1960 to August 1993. The interest rates and
inflation rates were converted to annualized values. The Belgian interest rate was the three-month
treasury certificates. The German interest rate was the FIBOR rate. The French, British and Dutch
nominal interest rates were the call money rates. The Italian rate used was the Treasury bond rate with
a 6-year average maturity. The Japanese and American nominal interest rates used were three-month
treasury bill rates. He analyzed the Fisher relation for these industrialized countries over the study
period. He found clear evidence that supports the Fisher theory in all the eight countries.
The research by Cooray (2002), surveyed the literature on the Fisher Effect. He stated that
while the majority of early studies confirmed Fishers findings of a distributed lag structure in the
formation of expectations, the evidence in respect of the models based on the theories of rational
expectations and efficient markets was mixed. He concluded that, although studies for the US appear to
suggest a positive relationship between interest rates and inflation, they did not establish a one-to-one
relationship as postulated by Fisher. He explained further that the evidence for the US seemed broadly
consistent with suggestions of the Fisher Effect, while results for other developed nations are not so
clear-cut. Studies for the developing nations suggest a high degree of consistency in results for the
Latin American countries with significant evidence of a Fisher Effect.
Crowder and Sonora (2002), in their study, used a data set on local city-wide interest rates and
local mortgage interest rates to construct a panel of Fisher relationships within the United States. In
their study, they attempted to exploit the cross-sectional information in a panel of Fisher equations
from different cities across the U.S. in the hope of yielding better estimates of the Fisher Effect in order
to determine whether or not real rates of interest are stationary, as implied by economic theory. The
research results were decidedly mixed. On the positive side, they found almost no evidence of non-
stationarity in the real interest rate.
The International Fisher Effect study by Sundqvist (2002), involved empirical investigation
using quarterly data for the nominal interest rates and exchange rates from different industrialized
countries over the period between 1993 and 2003. For the study, he selected Sweden, Japan, UK,
Canada, and Germany, countries with floating exchange rates, for a comparative study with the US. He
used regression analysis to examine the nominal interest differentials and the exchange rates change in
these countries. He concluded that the International Fisher Effect was only valid for the US and Japan.
Mishkin (1984) studied the real interest rate movements in seven OECD countries for the
period 1967 to 1979 in the euro deposit market. He found a close relationship between nominal interest
rates and expected rates of inflation for the UK, the US and Canada. He found that Germany, the

1
The change in exchange rate and the interest rate differential models are also used by Sundqvist (2002).

Netherlands, and Switzerland exhibited much weaker Fisher effect. Meanwhile, the research of
Mishkin and Simon (1995), using data spanning the period 19621993, found evidence of a long-run
Fisher relationship, but with no short-run effect.
Peng (1995) found a long-run relationship between interest rates and expected inflation for
France, the U.K and the U.S for the 19571994 period, using the Johansen (1988) and Johansen and
Juselius (1990) methodology. He concluded that the expected inflation had a much weaker impact on
interest rates in Germany and Japan. Meanwhile, Yuhn (1996) found evidence of a Fisher Effect in the
US, Germany and Japan, but little evidence in the U.K and Canada.
According to Fisher (1930) the real interest rate will remain unchanged in response to a
monetary shock if the Fisher Effect holds. The result has not been supported by evidence from some
empirical studies (Weber, 1994; King and Watson, 1997; Koustas and Serletis, 1999; and Rapach,
2003). Jensen (2006) also studied the long-run Fisher effect in seventeen industrialized countries,
namely, Australia, Austria, Belgium, Canada, Denmark, France, Germany, Greece, Ireland, Italy,
Japan, the Netherlands, Norway, Sweden, Switzerland, the United Kingdom, and the United States.
With using quarterly and monthly measures of inflation and short and long-term nominal interest rates,
he has found that, in the long run, inflation in these countries will be unaffected by a monetary shock.
Miyagawa and Morita (2003), attempt to assess the Fisherian link between inflation rate and
nominal interest rate. They use the quarterly data for Japan, Sweden and Italy. Their result suggests
that nominal interest rate do not respond to inflation rates point-for-point. These findings are also
consistent with the empirical evidence of United States by King and Watson (1997).
A study by Thomas (1985) tested the International Fisher Effect theory. In this study, Thomas
tested to find out whether high-interest-rate currencies depreciated and the low-interest-rate currencies
appreciated to the extent suggested by the International Fisher Effect theory. He indicated that the
theory does not hold, which is not to say that all MNCs should immediately place all excess cash in
high interest rate currencies.
Previous studies by Mishkin (1984), Adler and Dumas (1983), and Abuaf and Jorion (1990)
found evidence of significant deviations from the relationship between inflation rate differential and
exchange rate, persisting for lengthy periods. The work of Adler and Lehman (1983) provided
evidence against their result even over the long term. However, a research by Hakkio (1986) found that
the relationship between inflation rates differentials and exchange rates is not perfect even in the long
run, but it supports the use of inflation differentials to forecast long-run movements in exchange rates.
Finally, a study by Abuaf and Jorion (1990) find that even though exchange rates deviate from the
levels predicted by Purchasing Power Parity in the short run, their deviations are reduced over the long
run.

3. Hypotheses
Based on the International Fisher Effect theory (H1), the Fisher Effect theory (H2), and previous
studies reviewed above, we hypothesize that :
H1: The interest rate differential has positive significant influence on change in the exchange
rate.
H2: The inflation rate differential has positive significant influence on the interest rate
differential.

4. Research Methodology
4.1. Hypotheses Testing
a. Following the methodology of research used by Sundqvist (2002), Thomas (1985), and Hakkio
(1986), but with appropriate modification, we test the first hypotheses for four foreign

countries, namely, the US, Japan (JAP), Singapore (SING), and the UK, on home country,
Indonesia (IND), by using the following regression models :
/ USD IDR IND US
Y X o | c
= + - + (Model 6)
/ JPY IDR IND JAP
Y X o | c
= + - + (Model 7)
/ SGD IDR IND SING
Y X o | c
= + - + (Model 8)
/ GBP IDR IND UK
Y X o | c
= + - + (Model 9)
Where
Y
is the change in exchange rate, 1 t t
t
S S
S
+

, and
X
is the interest rate differential,
( )
( )
, ,
,
1
h t f t
f t
i i
i
+
.
b. Based on the studies of Miyagawa and Morita (2003), Jensen (2006), Peng (1995), Mishkin
(1984), Cooray (2002), and Crowder (2003), we test the hypothesis 2 by applying the following
regression model :
Y X o | c = + - + (Model 10)
Where
X
is the inflation rate differential,
( )
( )
, ,
,
1
h t f t
f t
I I
I
+
, and
Y
is the interest rate differential,
( )
( )
, ,
,
1
h t f t
f t
i i
i
+
.

4.2. Data Analysis
We will employ regression technique to analyze the data. The technique will then be applied, firstly to
the interest rate differential and the change in exchange rate, and secondly, to the inflation rate
differential on interest rate differential. The regression analysis tests whether interest rate differential is
a good forecast for change in the future spot exchange rates based on the International Fisher Effect
theory, and the influence of inflation rate differential on interest rate differential based on the Fisher
Effect theory.

4.3. Data Description
We have chosen 4 foreign industrialized countries for our study. These are the US, Japan, Singapore,
and the UK, with Indonesia as the home country. We have collected macroeconomic data from the
Central Bank of Indonesia
2
(BI) for a period of five years from 2003 to 2008. Data on interest rate is
the international interest rate. For the US and Japan we use yearly interest rate data. But for the UK, we
use LIBOR 3-month interest rate. For Singapore, we chose SIBOR 3-month interest rate, while for
Indonesia we use JIBOR 3-month interest rate. For exchange rate and interest rate data, we use
quarterly data from 2006 to 2008, and yearly data from 2003 to 2007.

5. Hypotheses Testing Results
5.1. Testing Results of Hypothesis 1a
Table 1 and 2 show model summary and coefficients for Indonesia-US interest rate differential to
change in the exchange rate based on regression model 6.

2
www.bi.go.id

Table 1: Model Summary for Indonesia-US Interest Rate Differential to Change in the Exchange Rate

.010
a
.000 -.037 .03735 2.515
Model
1
R
R
Squared
Adjusted
R Squared
Std. Error of
the Estimate
Durbin-
Watson
Predictors: (Constant), i_INDtoUS
a.
The actual R-Squared value is 0.0001, but the coloumn can only consist of 4 digits.

Table 1 shows the coefficient of determination, or simply R-squared. Its value is always
between 0 and 1, and interpreted as the percentage of variation in the response variables explained by
the regression line. R-squared
3
shows a predictor interest rate differential between Indonesia and the
US of 0.0001 with the change in exchange rate as dependent variable. This means that only 0.01 % of
the change in exchange rate of USD/IDR could be explained by the interest rate differential while
99.99% would be explained by other factors.

Table 2: Coefficients for Indonesia-US Interest Rate Differential to Change in the Exchange Rate

.000 .010 .020 .984
.001 .024 .010 .054 .957
(Constant)
i_INDtoUS
Model
1
B Std. Error
Unstandardized
Coefficients
Beta
Standardized
Coefficients
t Sig.
Actual constant -value shows in the table 2 is 0.0002

Table 2 above shows that the interest rate differential has positive but not significant influence
on change in the exchange rate, with 0.957 level of significance and 0.054 t-value, 0.0002 constant -
value
4
and 0.001 -value. The constant -value explains that the USD/IDR exchange rate will change
by 0.0002 % when Indonesia-US interest rate differential equals zero. The increase in interest rate
differential could be caused by the increase in interest rate of the home country, Indonesia, or the
decrease in interest rate of the foreign country, the US. The positive t-value indicates that when interest
rate differential is higher, IDR tend to depreciate against the USD as explained by the International
Fisher Effect theory. If the sign of change in exchange rate is positive, it would imply that IDR is
depreciating. On the other hand, if the sign of change in exchange rate is negative, the implication
would be that IDR is appreciating against USD.

5.2. Testing Results of Hypothesis 1b
Table 3 and 4 show model summary and coefficients for Indonesia-Japan interest rate differential to

Table 3: Model Summary for Indonesia-Japan Interest Rate Differential to Change in the Exchange Rate

.366
a
.134 .102 .04844 2.064
Model
1
R
R
Squared
Adjusted
R Squared
Std. Error of
the Estimate
Durbin-
Watson
Predictors: (Constant), i_INDtoJ AP a.

3
R-Squared shows in the table 1 with a predictor Indonesia-US interest rate differential and change in the exchange rate as
dependent variable, is 0.000. The actual value is 0.0001, but the coloumn can only consist of 4 digits.
4
Actual constant -value shows in the table 2 is 0.0002.

Table 3 shows R-squared, a predictor of interest rate differential between Indonesia and Japan
of 0.134, with change in exchange rate as dependent variable. This means that 13.4% of the exchange
rate change of JPY/IDR could be explained by the interest rate differential, while 86.6% are caused by
other factors.

Table 4: Coefficients for Indonesia-Japan Interest Rate Differential to Change in the Exchange Rate

.071 .033 2.186 .038
-.030 .015 -.366 -2.043 .050
(Constant)
i_INDtoJ AP
Model
1
B Std. Error
Unstandardized
Coefficients
Beta
Standardized
Coefficients
t Sig.

Table 4 shows that the interest rate differential between Indonesia and Japan has negative
significant effect on the exchange rate change, with 0.050 level of significance and -2.043 t-value,
0.071 constant -value, and -0.030 -value. The constant -value explains that if interest rate in
Indonesia and Japan are the same, the change in exchange rate would be 0,071%. The negative t-value
indicates that when interest rate differential is higher, IDR would appreciate against the JPY. Hence, if
the sign of change in exchange rate is positive, then IDR will appreciate. On the other hand, if the sign
of change is negative, it will imply that IDR is depreciating against JPY. This finding is contrary with
the International Fisher Effect theory.

5.3. Testing Results of Hypothesis 1c
Table 5 and 6 show model summary and coefficients for Indonesia-Singapore interest rate differential
to change in the exchange rate based on regression model 8.

Table 5: Model Summary for Indonesia-Singapore Interest Rate Differential to Change in the Exchange Rate

.026
a
.001 -.036 .03712 2.388
Model
1
R
R
Squared
Adjusted
R Squared
Std. Error of
the Estimate
Durbin-
Watson
Predictors: (Constant), i_INDtoSING
a.

Table 5 shows R-squared, a predictor interest rate differential between Indonesia and Singapore
of 0.001 with the change in exchange rate as a dependent variable. This means that 0.1 % of the change
in exchange rate of SGD/IDR could be explained by the interest rate differential and 99.90 % would be
explained by other factors.

Table 6: Coefficients for Indonesia-Singapore Interest Rate Differential to Change in the Exchange Rate

.012 .012 .997 .328
.001 .010 .026 .135 .894
(Constant)
i_INDtoSING
Model
1
B Std. Error
Unstandardized
Coefficients
Beta
Standardized
Coefficients
t Sig.

Table 6 above shows the interest rate differential that has positive but not significant influence
on the exchange rate change, with 0.894 level of significance and 0.135 t-value, 0.012 constant -
value, and 0.001 -value. The interpretation of the constant -value is that SGD/IDR exchange rate

will change by 0.012 % when the Indonesia-Singapore interest rate differential equals zero. The
positive t-value means that when interest rate differential is higher, IDR would tend to depreciate
against SGD as implied by the International Fisher Effect theory. If the sign of change in exchange rate
is positive, it indicates that IDR is depreciating. On the other hand, if the sign of change in exchange
rate is negative, it shows that IDR is appreciating against SGD. Meanwhile, the increase in interest rate
differential could be caused by the increase in the interest rate of the home country, Indonesia, or the
decrease in the interest rate of the foreign country, Singapore.

5.4. Testing Results of Hypothesis 1d
Table 7 and 8 show model summary and coefficients for Indonesia-UK interest rate differential to

Table 7: Model Summary for Indonesia-UK Interest Rate Differential to Change in the Exchange Rate

.299
a
.089 .056 .04267 2.544
Model
1
R
R
Squared
Adjusted
R Squared
Std. Error of
the Estimate
Durbin-
Watson
Predictors: (Constant), i_INDtoUK
a.

Table 7 shows the R-squared, a predictor interest rate differential between Indonesia and the
UK of 0.089 with the change in exchange rate as dependent variable. This means that 8.9 % of the
change in exchange rate of GBP/IDR could be explained by the interest rate differential and 91.1 % by
other factors.

Table 8: Coefficients for Indonesia-UK Interest Rate Differential to Change in the Exchange Rate

-.005 .014 -.340 .736
.018 .011 .299 1.629 .115
(Constant)
i_INDtoUK
Model
1
B Std. Error
Unstandardized
Coefficients
Beta
Standardized
Coefficients
t Sig.

In table 8 the interest rate differential has positive but not significant effect on the exchange rate
change, with 0.115 significance level and 1.629 t-value, -0.005 constant -value and 0.018 -value.
The constant -value implies that if interest rates in Indonesia and the UK are the same, the change in
exchange rate would be -0.005 %. The positive t-value illustrates that when interest rate differential is
higher, IDR would depreciate against GBP. If the sign of exchange rate change is positive, it would
imply that IDR is depreciating. On the other hand, if the sign of the change in exchange rate is
negative, it explains that IDR is appreciating on GBP. The increase in interest rate differential could be
caused by the increase in the interest rate of the home country, Indonesia, or the decrease in the interest
rate of the foreign country, the UK.

5.5. Testing Results of Hypothesis 2
Table 9 and 10 show model summary and coefficients of inflation rate differential to interest rate
differential based on regression model 10.


Table 9: Model Summary of Inflation Rate Differential to Interest Rate Differential

.515
a
.265 .247 .94734 1.266
Model
1
R
R
Squared
Adjusted
R Squared
Std. Error of
the Estimate
Durbin-
Watson
Predictors: (Constant), InflationRates
a.

Table 9 also shows the R-squared, a predictor inflation rate differential for Indonesia-US,
Indonesia-Japan, Indonesia-Singapore, and Indonesia-UK of 0.265 with interest rate differential as
dependent variable. This means that 26.5 % of interest rates differential could be explained by the
inflation rates differential and 73.5 % by other factors.

Table 10: Coefficients of Inflation Rate Differential to Interest Rate Differential

1.773 .195 9.098 .000
.105 .027 .515 3.843 .000
(Constant)
InflationRates
Model
1
B Std. Error
Unstandardized
Coefficients
Beta
Standardized
Coefficients
t Sig.

Table 10 displays that inflation rate differential has positive significant influence on interest
rate differential, with 0.000 level of significance and 3.843 t-value, 1.773 constant -value, and 0.105
-value. The description of the constant -value is that the interest rate differential will change by
1.773 % when the inflation rate differential equals zero. Meanwhile, the positive t-value shows that the
higher the inflation rate differential between Indonesia-US, Indonesia-Japan, Indonesia-Singapore, and
Indonesia-UK, the higher the interest rate differential between them. The increase in interest rate
differential could be caused by the increase in interest rate of the home country, or the decrease in the
interest rate of the four foreign countries. The increase in inflation rate differential could be also caused
by the increase in inflation rate of the home country, Indonesia, or the decrease in inflation rate of
those foreign countries, the US, Japan, Singapore, and the UK.

5.6. The Interest Rate Differential and Change in the Exchange Rate
Figure 1, 2, 3, and 4 show the movement of IndonesiaUS, IndonesiaJapan, IndonesiaSingapore, and
IndonesiaUK interest rate differentials and changes in the exchange rate.

Figure 1: IndonesiaUS Interest Rate Differential and Change in Exchange Rate

interest rate differential
exchange rate change
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
2003 2004 2005 2006 2007


Figure 2: IndonesiaJapan Interest Rate Differential and Change in Exchange Rate

-0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
2003 2004 2005 2006 2007

Figure 3: IndonesiaSingapore Interest Rate Differential and Change in Exchange Rate

exchange rate change
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
2003 2004 2005 2006 2007

Figure 4: IndonesiaUK Interest Rate Differential and Change in Exchange Rate

-0.5
0
0.5
1
1.5
2
2.5
3
3.5
2003 2004 2005 2006 2007


Figure 1, 3, and 4 display the interest rate differentials between Indonesia-US, Indonesia-
Singapore, and Indonesia-UK interest rates, and as well as the exchange rate changes between the these
countries. As in 2005 interest rate in the home country hit the highest level within the period of
research, figure 1 shows that the highest interest rate differential between Indonesia and the US
occurred in 2005, and the lowest in 2007. Meanwhile, the highest IDR depreciation was in 2004, and
the lowest in 2003.
Figure 2 shows Indonesia-Japan interest rate differential and the exchange rate change.
Consistent with the result of Indonesia-US, figure 2 indicates that the highest interest rate differential
between Indonesia-Japan was also in 2005, and the lowest rate in 2007. Meanwhile, the highest IDR
appreciation against JPY was in 2004, and the lowest appreciation was in 2006.
We can observe from the figure 3 that the year of the highest IDR depreciation against SGD
was in 2004, and the lowest in 2003. As the interest rates of the two foreign countries, Singapore and
the UK, reached the lowest level in 2003 and the highest level in 2007, these rates have caused the
highest interest rate differentials between Indonesia-Singapore (figure 3) and Indonesia-UK (figure 4)
occurred in 2003, and the lowest in 2007. However, the highest depreciation of the IDR against GBP
occurred in 2004, while the lowest took place in 2005.

5.7. The Inflation Rate and Interest Rate Differentials
Figure 5, 6, 7, and 8 show the movement of IndonesiaUS, IndonesiaJapan, IndonesiaSingapore, and
IndonesiaUK inflation rates and interest rates differentials.

Figure 5: IndonesiaUS Inflation and Interest Rate Differentials

0
0.5
1
1.5
2
2.5
3
3.5
2003 2004 2005 2006 2007
Inflation rate differential

Figure 6: IndonesiaJapan Inflation and Interest Rate Differentials

0
2
4
6
8
10
12
14
16
18
20
2003 2004 2005 2006 2007


Figure 7: IndonesiaSingapore Inflation and Interest Rate Differentials

Inflation rate differential
0
1
2
3
4
5
6
7
8
2003 2004 2005 2006 2007

Figure 8: IndonesiaUK Inflation and Interest Rate Differentials

0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
2003 2004 2005 2006 2007

Figure 5 displays the inflation rate and interest rate differentials between Indonesia and the US.
The highest inflation rate differential between Indonesia and the US was in 2006, while the lowest was
in 2007. The same result also shown by figure 8 for Indonesia-UK inflation rate differential.
Meanwhile, the highest Indonesia-US interest rate differential was in 2005, and the lowest rate was in
2007. However, the highest Indonesia-UK interest rate differential was registered in 2003, and the
lowest in 2007 as illustrated by figure 8.
The inflation rate and interest rate differentials between Indonesia and Japan are shown in
figure 6. It indicates that the highest inflation rate differential between Indonesia and Japan was in
2005, and the lowest rate in 2004. The highest interest rate differential was in 2005, and the lowest in
2007.
Figure 7 displays the inflation rate differential between Indonesia and Singapore, as well as the
interest rate differential between the two countries. In addition, the figure indicates that the highest
inflation rate differential between Indonesia and Singapore was in 2005, and the lowest rate in 2007.
Meanwhile, the highest interest rate differential was in 2003, while the lowest rate was in 2007.
Hence, overall we conclude that the year with the lowest interest rate and inflation rate
differentials within the sampling period was in 2007, as the regression result shows that the inflation
rate differential has a positive effect on the interest rate differential.

6. Conclusion
Our regression results have shown that the interest rate differentials have positive but not significant
influence on the US, Singapore, and the UK exchange rate changes relative to Indonesian currency.
The implication of these results is that the higher the interest rate differentials between Indonesia and
these countries, the higher the change in exchange rate. We can therefore argue that, when interest rate
differential is higher, IDR would depreciate against USD, SGD, and GBP. This evidence concludes
that the International Fisher Effect holds but is not significant for the US, Singapore, and the UK.
On the other hand, the interest rate differential has negative significant influence on the change
in exchange rate for Japan. Therefore, when interest rate differential is higher, IDR would appreciate
against JPY. But, this finding is not consistent with what suggested by the International Fisher Effect
theory as when home interest rate is higher than foreign interest rate the foreign currency value will
appreciate. Therefore the theory also does not hold in Japan.
Based on these results, a conclusion that can be drawn is that the interest rate differential might
not be applied accurately to predict the change in future exchange rate based on a quarterly or yearly
sample, such as ours in this study which covered the period 2003 to 2008, as suggested by the
International Fisher Effect theory.
Regression results also show that the inflation rate differential has positive significant influence
on the interest rate differential, thereby indicating that when inflation rate differential increases, the
interest rate differential will also increase. This means that the Fisher Effect holds for inflation rate and
interest rates differentials in Indonesia against the four study foreign countries of USA, Japan,
Singapore, and the UK.
Meanwhile, R-squared for Indonesia and Japan would seem much more accurate than those of
the other three countries. The overall R-squared, with interest rate differential as dependent, and
inflation rate differential as independent variable is also a much better predictor of interest rate
differential. However, the beta values for all country pairs in our study are very low. This implies a
reaction of the change in exchange rate to other factors in addition to nominal interest rate differential.
Another possible explanation could be failure of change in exchange rate to offset nominal interest rate
differentials.

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Appendix
Regression Results

Table 1: Descriptive Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change

.0006 .03668
.2824 .29603
S_IDRtoUSD
i_INDtoUS
Mean Std. Deviation


Table 2: Correlations for Indonesia-US Interest Rate Differential and Exchange Rate Change

1.000 .010
.010 1.000
. .479
.479 .
29 29
29 29
S_IDRtoUSD
i_INDtoUS
S_IDRtoUSD
i_INDtoUS
S_IDRtoUSD
i_INDtoUS
Pearson Correlation
Sig. (1-tailed)
N
S_IDRtoUSD i_INDtoUS

Table 3: Anova for Indonesia-US Interest Rate Differential and Exchange Rate Change

.000 .000 .003 .957
a
.038 .001
.038
Regression
Residual
Total
Model
1
Sum of
Squares Mean Square F Sig.
Predictors: (Constant), i_INDtoUS
a.

Table 4: Residual Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change

.0002 .0017 .0006 .00038
-.09741 .09651 .00000 .03668
-1.053 2.901 .000 1.000
-2.608 2.584 .000 .982
Predicted Value
Residual
Std. Predicted Value
Std. Residual
Minimum Maximum Mean Std. Deviation

Table 5: Descriptive Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate
Change

.0072 .05111
2.1516 .62860
S_IDRtoJ PY
i_INDtoJ AP
Mean Std. Deviation

Table 6: Correlations for Indonesia-Japan Interest Rate Differential and Exchange Rate Change

1.000 -.366
-.366 1.000
. .025
.025 .
29 29
29 29
S_IDRtoJ PY
i_INDtoJ AP
S_IDRtoJ PY
i_INDtoJ AP
S_IDRtoJ PY
i_INDtoJ AP
Pearson Correlation
Sig. (1-tailed)
N
S_IDRtoJ PY i_INDtoJ AP


Table 7: Anova for Indonesia-Japan Interest Rate Differential and Exchange Rate Change

.010 .010 4.173 .050
a
.063 .002
.073
Regression
Residual
Total
Model
1
Sum of
Predictors: (Constant), i_INDtoJ AP
a.

Table 8: Residual Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate
Change

-.0748 .0257 .0072 .01870
-.09649 .13537 .00000 .04757
-4.386 .989 .000 1.000
-1.992 2.795 .000 .982
Predicted Value
Residual
Std. Residual

Table 9: Descriptive Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate
Change

.0133 .03646
.9921 .70953
S_IDRtoSGD
i_INDtoSING
Mean Std. Deviation

Table 10: Correlations for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change

1.000 .026
.026 1.000
. .447
.447 .
29 29
29 29
S_IDRtoSGD
i_INDtoSING
S_IDRtoSGD
i_INDtoSING
S_IDRtoSGD
i_INDtoSING
Pearson Correlation
Sig. (1-tailed)
N
S_IDRtoSGD i_INDtoSING

Table 11: Anova for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change

.000 .000 .018 .894
a
.037 .001
.037
Regression
Residual
Total
Model
1
Sum of
Predictors: (Constant), i_INDtoSING
a.


Table 12: Residual Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate
Change

.0125 .0164 .0133 .00095
-.06454 .12751 .00000 .03645
-.855 3.331 .000 1.000
-1.739 3.435 .000 .982
Predicted Value
Residual
Std. Residual

Table 13: Descriptive Statistics for Indonesia-UK Interest Rate Differential and Exchange Rate
Change

.0136 .04391
.9951 .71327
S_IDRtoGBP
i_INDtoUK
Mean Std. Deviation

Table 14: Correlations for Indonesia-UK Interest Rate Differential and Exchange Rate Change

1.000 .299
.299 1.000
. .058
.058 .
29 29
29 29
S_IDRtoGBP
i_INDtoUK
S_IDRtoGBP
i_INDtoUK
S_IDRtoGBP
i_INDtoUK
Pearson Correlation
Sig. (1-tailed)
N
S_IDRtoGBP i_INDtoUK

Table 15: Anova for Indonesia-UK Interest Rate Differential and Exchange Rate Change

.005 .005 2.652 .115
a
.049 .002
.054
Regression
Residual
Total
Model
1
Sum of
Predictors: (Constant), i_INDtoUK
a.

Table 16: Residual Statistics for Indonesia-UK Interest Rate Differential and Exchange Rate Change

.0024 .0575 .0136 .01313
-.09204 .14954 .00000 .04190
-.854 3.337 .000 1.000
-2.157 3.504 .000 .982
Predicted Value
Residual
Std. Residual


Table 17: Descriptive Statistics of Inflation Rate and Interest Rate Differential

2.2749 1.09160
4.7820 5.34761
InterestRates
InflationRates
Mean Std. Deviation

Table 18: Correlations of Inflation Rate and Interest Rate Differential

1.000 .515
.515 1.000
. .000
.000 .
43 43
43 43
InterestRates
InflationRates
InterestRates
InflationRates
InterestRates
InflationRates
Pearson Correlation
Sig. (1-tailed)
N
InterestRates InflationRates

Table 19: Anova of Inflation Rate and Interest Rate Differential

13.251 13.251 14.765 .000
a
36.796 .897
50.047
Regression
Residual
Total
Model
1
Sum of
Predictors: (Constant), InflationRates
a.

Table 20: Residual Statistics of Inflation Rate and Interest Rate Differential

1.8981 4.9938 2.2749 .56170
-2.07615 2.32436 .00000 .93600
-.671 4.840 .000 1.000
-2.192 2.454 .000 .988
Predicted Value
Residual
Std. Residual

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