Exchange Rate and Economic Growth in Indonesia (1984-2013) Name: Shanty Tindaon JEL : E47 Keywords: Economic Growth, FDI, Inflation, Indonesia Abstract: This paper examines the impact of FDI, capital stock, inflation, and nominal exchange rate on economic growth of Indonesia by using time series data for the period of 1984-2013. Augmented Dickey Fuller (ADF) test is employed to check the stationary of variables. All variables are stationary at level. So Ordinary Least Squares method is applied to check the relation between dependent variable (GDP) and independent variables (FDI, capital stock, inflation, and nominal exchange rate). The Cochrane-Orcutt iterative method also used to correct the autocorrelation. The results shows that Foreign direct investment has positive and significant relation with the GDP of Indonesia, Inflation has negative relation with the GDP of Indonesia while Capital Stock and Nominal Exchange Rate do not significantly affect economic growth. My model is free from heteroscedasticity using the Q square test also it is distributed normally by using the JB normality test. There is need to attract investors by creating peaceful environment in the country also, the government should take significant steps to increase the standard of exporting goods in the trade.
1. Introduction Exchange rate is the macroeconomic policy instrument. It has a vital role in determining the route of balance of trade. Beside, the relationship between exchange rate and economic growth has been an important subject in economics. Exchange rate means how many units of one nation s currency can be purchased with one unit of domestic currency (Ahmad, et all, 2013). It is usually used as an indicator of the growth of economy in all the countries, included Indonesia. Indonesia's economy has experienced the falldown in the current foreign exchange trade, it is also experienced a downfall in the Asian region. In 2009 rupiah decreased up to Rp. 12000. Initially, the government hopes the exchange rate back to a level of Rp. 9400 per USD, but changed into USD. 11000 per USD. Recently, the rupiah is having a slightly appreciation of the dollar, 1 USD is equal to Rp. 13600. Exchange rate can effect some macroeconomic aspects. For example, if there is depreciation in the exchange rate of domestic currency against foreign currencies, it will cause an increase in inflation as a result of the process of pass through effect (Isnowati, 2015). Isnowati (2015) stressed that the economy in Indonesia is highly affected by exchange rate movements, and it is not free from the dynamics that occur in the external and domestic macro economy. From the beginning that the application of free floating applied in Indonesian exchange rate, it becomes highly fluctuating. Indonesia is one of the most influence countries in Asia. With the GDP expected to reach US$ 1 trillion in 2012, Indonesia is the largest economy in Southeast Asia. Much less affected by the global financial crisis compared to its neighboring countries, Indonesia s economy grew by 5.7% in 2013, making The World s Most Stable Economy in the Last Five Years according to The Economist Magazine (Irsania and Noveria, 2014). There in increasing in Indonesia economic growth by 6.2% in 2012 and in 2014, stronger economic
growth is expected around the lower end of the 5.8 6.2% range. Future economic expansion is expected to include more inclusive growth as nominal per capita GDP is expected to quadruple by 2020, according to a Standard Chartered report (bkpm.go.id, 2014). The purpose of this paper is to investigate the relationship between exchange rate and economic growth of Indonesia. Theoretically, there exists a positive relationship between high exchange rate and economic growth, which suggest that devaluation/ depreciation enhance economic growth. Other factor that also affect the economic growth is Capital Stock which is here proxied by GFCF (Gross Fixed Capital Formation). The figure below shows that there is a negative relationship between nominal exchange rate and economic growth of Indonesia. 1.1 Figure 1 Economic Growth VS Nominal Exchange Rate in Indonesia 100 90 80 70 60 50 40 30 20 10 0 1980 1985 1990 1995 2000 2005 2010 2015 Nominal Exc Economic Growth This research began with the introduction, followed by literature review then the methodology used in the model followed by the analytical tools used, the testing application, discussion of research results, and make the conclusion.
2. Literature Review Economic growth is measured by GDP. GDP is one of good indicator of a country's microeconomic status and development. This section will talk about the previous research that had been conducted about this paper; the economic growth. Rodrik (2008) found that there is a relationship between exchange rates and economic growth to form positive relationships. Ugochukwu and Chinyere (2013) found that capital formation has positive and significant impact on economic growth in Nigeria for the period of 2013. They said that stock market also showed a positive impact, while both inflation rate and interest rate has a negative impact on economic growth in Nigeria. FDI is the term of investment made to gain the lasting interest in an enterprise operating in an economy other than that of the investor, it is mostly carried out by multinational corporations. Foreign direct investment is another important variable that can affect the economic growth. Most of the researchers are agree with the point that FDI is working as an engine for economic growth of the country (Ahmad et all, 2013). Regarding to the literature review, the researcher namely Olokoyo (2012) examined the effects of FDI on the development of the Nigerian economy. The results shows that exchange rate, balance of payment and FDI have negative impacts on the Nigerian economy. On the other hand, Irsania and Novaria (2014) found the result that FDI, inflation rate, and exchange rate has a significant influence towards the economic growth. The two of them which are exchange rate and inflation rate show a significant influence toward the economic growth. Meanwhile, they found that FDI also have a significant influence toward the economic growth. Their findings showed that if FDI and unemployment rate increase, then Indonesia s economic growth will also increase. Recently, Semuel and Nurina (2015) conducted the research entitled Analysis of the Effect of Inflation, Interest Rates, and Exchange Rates on Gross Domestic Product (GDP) in
Indonesia. They found that there is a significant positive effect on GDP and exchange rates. In line with positive relationship between exchange rate and GDP, Qichun He (2010) also found the relationship between exchange rate and econmic growth in China. He views that China adopted fixed exchange rate policy and made rapid economic growth. He further adds that fix exchange rate cause the promotion of long run productivity. Foreign direct investment to be another important part of macroeconomic that affect the economic growth. Most of the researchers are agree with the point that FDI is working as an engine for economic growth of the country. They are in a view that without the sufficient amount of FDI it is quite impossible to make sustainable growth (Ahmad et all, 2013). 3. Data Collection And Methodology Multiple regression analysis is used to find the relationship between the variables. We used secondary data that is collected from the official economic survey of Pakistan and WDI. Economic growth is taken as dependent variable. Inflation, FDI, nominal exchange rate and Gross fixed capital formation (GFCF) are use as independent variables for the period of 1975 to 2011. Econometric model is given below: Ln(EG t )=β 0 +β 1 ln(inf t )+β 2 ln(fdi t )+β 3 ln(exc t )+β 4 ln(cs t )+Ɛ t Where EG=Economic Growth INF=Inflation FDI=Foreign Direct Investment EXC= Nominal Exchange Rate CS=Capital stock proxies by gross fixed capital formation (GFCF) Ɛ t =Stochastic Error Term Where, β0, β1, β2, β3, β4 are the respective parameters.
The estimation commences with a unit root test is used to confirm the stationarity state of the variables that entered the model. In order to test for the stationarity, the Augmented Dicky Fuller test will be applied. The first step is to test the stationarity at level. If the variable are not stationary, then the next step is to make the difference and test for the stationarity of the differenced variables. If the variables are stationary after the first differencing, then the variables are integrated of order one or we can symbolize 1(1). After that OLS model will be applied. If there is the presence of autocorrelation, the model would be corrected using Cochrane-Orcutt estimation. Augmented Dickey Fuller test is used to check the stationary level. This down below is the results of unit roots test. The result shows that all of variables are integrated of order zero [I (0)], so we can use Ordinary Least Square (OLS). The results of OLS are given in table 1.2: Table 1.1 Null Hypothesis: There is unit root; Alternative Hypothesis: There is no unit root Variables Level and first Difference Trend Drift Conclusion Ln (EG) Level 0.049 0.011 I (0) Level 0.857 0.919 Unit root Ln FDI 1st Difference Level 0.036 0.0002 I (1) GFCF Level 0.689 0.804 Unit root 1st Difference Level 0.354 0.162 Unit root 2nd Difference Level 0.001 0.0003 I (2) Ln EXC Level 0.007 0.001 I (0) Ln Inflation Level 0.344 0.71 Unit root 1st Difference Level 7.27E-02 8.47E-03 I (1) Note: *All the variables are compared to with the critical value at 5% level of significance
. Coefficient Std. Error t-ratio p-value Const 8,582 0,657 13,046 <0,0001 *** d_fdi 8,77212e-011 1,26798e-010 0,691 0,496 d_d_gfcf 1,95049e-012 3,9608e-011 0,049 0,961 INFLATION 0,315 0,067 4,668 0,0001 *** d_nominalexc 0,0003 0,0005 0,598 0,555 Table 1.2 : Results of Ordinary Least Squares Method Mean dependent var 5,360 S.D. dependent var 4,031 Sum squared resid 72,692 S.E. of regression 1,777 R-squared 0,834 Adjusted R-squared 0,805 F(4, 23) 28,968 P-value(F) 1,11e-08 Log-likelihood 53,086 Akaike criterion 116,173 Schwarz criterion 122,834 Hannan-Quinn 118,210 Rho 0,702 Durbin-Watson 0,590 Table 1.2 shows a relationship between the dependent variable (GDP) and the independent variables (FDI, GFCF, Inflation and Nominal Exchange rate). From the result above, it shows that Durbin-Watson is not a good fit. As a result of the presence of autocorrelation (as shown in the Durbin-Watson indicating 0,590 ), so the Cochrane-Orcutt iteration method was used to correct this. This down below is the result of Cochrane Orcutt Iterative Method
Table 1.3 Cochrane Orcutt Iterative Method Coefficient Std. Error t-ratio p-value const 8,172 1,057 7,726 <0,0001 *** d_fdi d_d_gfcf 1,27114e- 010 3,77065e- 013 6,86412e-011 1,851 0,077 * 2,56742e-011 0,014 0,988 INFLATION 0,272 0,038 6,986 <0,0001 *** d_nominalexc 0,0003 0,0003 1,171 0,253 Mean dependent var 5,338148 S.D. dependent var 4,106946 Sum squared resid 30,884 S.E. of regression 1,184 R-squared 0,930 Adjusted R-squared 0,918 F(4, 22) 75,343 P-value(F) 1,63e-12 Rho 0,201 Durbin-Watson 1,594 Statistics based on the rho-differenced data: The results of Cochrane Orcutt Iterative Method show that FDI and inflation have negative relation with the GDP of Pakistan. Especially for the result of inflation with 1% of significance level. The result of inflation shows that one percent increase in inflation will decrease GDP by 0.27%. while the result of foreign direct investment shows that one percent increase in FDI will raise GDP by 1.27% percent. Both gross fixed capital formation and nominal exchange rate has negative and insignificant affect on economic growth of Pakistan. The elasticity of gross fixed capital formation and exchange rate is 3.77 and 0.0003
respectively. The value of R2 (coefficient of determination) in of this model is 91.8% of the variations in the dependent variable (ln EG) is due to independent variables included in the Probability Item Test Applied Critical Value Value Normality JB Normality test on residuals 0,268 0,874 Heteroscedasticity Q 2 test on residuals 0,196 0,657 model. Now the model is free from the problem of autocorrelations (DW value=1,594). Table 1.3 Diagnostic Test Table 1.3 shows the normality and heteroscedasticity tests. The results of diagnostic tests demonstrate that this model is free from hetroscedasticity and the variance is normally distributed. 4. Conclusion and policy implication This study examines the impact of foreign direct investment, capital stock, inflation, exchange rate and on the economic growth of Indonesia by using the annual data for the period of 1984 2013. Multiple regression technique is used to analyze the relationship between dependent variable (Economic growth) and independent variables (FDI, exchange rate, inflation and Capital stock). Results indicate that inflation and foreign direct investment significantly affect the economic growth of Indonesia, whereas gross fixed capital formation and inflation does not significantly affect economic growth. Foreign direct investment has positive relation with gross domestic product of Indonesia as it is considered as a booster for the economic growth of the country. There is need to attract investors by creating peaceful environment in the country. In other side, inflation is significantly effect the economic growth means that this can leads to the depreciation of the growth. Nominal exchange rate has negative relation with economic growth of Indonesia. Our model is free from
hetroskedasticity and normality test suggests the stability and the normality of the model. Indonesia is the developing country, it needs to import large quantities of materials and capital goods for its development. That is why the demand for foreign exchange is more that leads to depreciation of its exchange rate and in this way economic growth will be affected. Indonesia now is is facing severe crisis and threats for economic moreover the currency value now tends to be in bad condition. Balance of trade is the most important problem. Following measure should be taken to minimize trade deficit, which in turn guarantees economic growth.. Industrial based agriculture production should be encouraged. Reference: Olokoyo. 2012. Foreign Direct Investment And Economic Growth: A Case Of Nigeria. Bvimsr s journal of management research, vol. 4, no 1, april 2012. Ugochukwu and Chinyere. 2013. The Impact of Capital Formation on the Growth of Nigerian Economy. Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.4, No.9, 2013 Semuel. 2015. Analysis of the Effect of Inflation, Interest Rates, and Exchange Rates on Gross Domestic Product (GDP) in Indonesia. International Conference on Global Business, Economics, Finance and Social Sciences (GB15_Thai Conference) ISBN: 978-1- 941505-22-9 Bangkok, Thailand, 20-22 February 2015 Paper ID: T507. Indonesian investment Coordinating Board Official. http://www7.bkpm.go.id/contents/general/4/sound-economy Isnowati. 2015. Effect Of Exchange Rate, National Income, And Inflation On Import Price In Indonesia. International Lournal Bussiness Economics and Law 08/2015; 7(3). Irsania and Noveria. 2014. The Relationship Among Foreign Direct Investment, Inflation Rate, Unemployment Rate, And Exchange Rate To Economic Growth In Indonesia. Journal Of Business And Management Vol. 3, No.5, 2014: 499-510 Economic Growth: http://www.theglobaleconomy.com/indicators_data_export.php FDI: https://research.stlouisfed.org/fred2/series/bpfadi03ida637n/downloaddata GFCF: http://www.indexmundi.com/facts/indonesia/gross-fixed-capital-formation INFLATION: https://research.stlouisfed.org/fred2/series/fpcpitotlzgidn/downloaddata Nominal EXC: http://www.ers.usda.gov/datafiles/agricultural_exchange_rate_data_set/country_spreadsheet s/nominalannualcountryexchangerates_1_.xls All the Data can be downloaded in this link https://drive.google.com/folderview?id=0b2ado8y1yhfcv2rqbjn6axfummc&usp=sharing