International Research Journal of Finance and Economics ISSN 1450-2887 Issue 26 (2009) EuroJournals Publishing, Inc. 2009 http://www.eurojournals.com/finance.

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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,

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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 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 r = (1 + i f )(1 + e f ) 1 , where r is the actual returns to investors, if is the foreign interest rate, and ef 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, ih , 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 ih , E (r ) = ih . In order to make investments in both home and foreign countries to yield similar returns, r is set equal to ih, and the foreign currency must change to make r = ih . Therefore (1 + i f )(1 + e f ) 1 = ih , where r is the effective return on the foreign deposit and ih is the interest rate on the home deposit. The (1 + ih ) formula of ih is expressed as (1 + i f )(1 + e f ) = (1 + ih ) , and (1 + e f ) = (1 + i f ) , to determine for the foreign currency value (ef). Finally, the International Fisher Effect function would be formulated as:

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(1 + i ) 1
f

(1 + ih )

(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 + I h ) ef = (Model 2) (1 + I f ) 1 Model 2 indicates that when home inflation rate, Ih, is higher than foreign inflation rate, If, 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 + ih ) (1 + I h ) (Model 3) 1 = (1 + i f ) (1 + I f ) 1 By combining model 1 and model 2, we have : (1 + ih ) (1 + I h ) ef = (Model 4) 1 = (1 + i f ) (1 + I f ) 1
S t +1 S t to determine the change in St its value. Therefore, model 4 and 5 are expressed to show how the exchange rate change, interest rate, and inflation rate differentials are related :

The value of the foreign currency, ef, will be formulated as

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S t +1 S t (ih ,t i f ,t ) (I h ,t I f ,t ) = (1 + i f ,t ) = (1 + I f ,t ) St

154
(Model 5)1

Where S t +1 is the spot exchange rate at time t+1, S t is the domestic currency value of one unit of foreign currency at time t, ih ,t is interest rate at time t in the home country, i f ,t is interest rate at time t in the foreign country, I h ,t is inflation rate at time t in the home country, I f ,t 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 nonstationarity 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 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
1

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

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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 : YUSD / IDR = + X IND US + (Model 6)

YJPY / IDR = + X IND JAP + YSGD / IDR = + X IND SING + YGBP / IDR = + X IND UK +

(Model 7) (Model 8) (Model 9)

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Where Y is the change in exchange rate,

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(i i ) (1 + i ) .
h ,t f ,t f ,t

S t +1 S t , and X is the interest rate differential, St

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 + (Model 10) (I h,t I f ,t ) Where X is the inflation rate differential, (1 + I f ,t ) , and Y is the interest rate differential,

(i i ) . (1 + i )
h ,t f ,t f ,t

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.

www.bi.go.id

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Table 1:

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

Model 1

R .010a

R Squared .000

Adjusted R Squared -.037

Std. Error of the Estimate .03735

DurbinWatson 2.515

a. Predictors: (Constant), i_INDtoUS

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

Model 1

(Constant) i_INDtoUS

Unstandardized Coefficients B Std. Error .000 .010 .001 .024

Standardized Coefficients Beta .010

t .020 .054

Sig. .984 .957

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 change in the exchange rate based on regression model 7.
Table 3: Model Summary for Indonesia-Japan Interest Rate Differential to Change in the Exchange Rate

Model 1

R .366 a

R Squared .134

Adjusted R Squared .102

Std. Error of the Estimate .04844

DurbinWatson 2.064

a. Predictors: (Constant), i_INDtoJAP

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. Actual constant -value shows in the table 2 is 0.0002.

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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
Unstandardized Coefficients B Std. Error .071 .033 -.030 .015 Standardized Coefficients Beta -.366

Model 1

t 2.186 -2.043

Sig. .038 .050

(Constant) i_INDtoJAP

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

Model 1

R .026a

R Squared .001

Adjusted R Squared -.036

Std. Error of the Estimate .03712

DurbinWatson 2.388

a. Predictors: (Constant), i_INDtoSING

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
Unstandardized Coefficients B Std. Error .012 .012 .001 .010 Standardized Coefficients Beta .026

Model 1

t .997 .135

Sig. .328 .894

(Constant) i_INDtoSING

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 -

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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 change in the exchange rate based on regression model 9.
Table 7: Model Summary for Indonesia-UK Interest Rate Differential to Change in the Exchange Rate

Model 1

R .299a

R Squared .089

Adjusted R Squared .056

Std. Error of the Estimate .04267

DurbinWatson 2.544

a. Predictors: (Constant), i_INDtoUK

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
Unstandardized Coefficients B Std. Error -.005 .014 .018 .011 Standardized Coefficients Beta .299

Model 1

t -.340 1.629

Sig. .736 .115

(Constant) i_INDtoUK

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.

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

160

Model 1

R .515a

R Squared .265

Adjusted R Squared .247

Std. Error of the Estimate .94734

DurbinWatson 1.266

a. Predictors: (Constant), InflationRates

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
Unstandardized Coefficients B Std. Error 1.773 .195 .105 .027 Standardized Coefficients Beta .515

Model 1

t 9.098 3.843

Sig. .000 .000

(Constant) InflationRates

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.

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

1.2 1 0.8 0.6 0.4 0.2 0 -0.2

2003

2004

2005

2006

2007

interest rate differential exchange rate change

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

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5

2003

2004

2005

2006

2007

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

3.5 3 2.5 2 1.5 1 0.5 0 -0.5

2003

2004

2005

2006

2007

interest rate differential exchange rate change

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

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3.5 3 2.5 2 1.5 1 0.5 0 -0.5

2003

2004

2005

2006

2007

Figure 1, 3, and 4 display the interest rate differentials between Indonesia-US, IndonesiaSingapore, 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
3.5 3 2.5 2 1.5 1 0.5 0

2003

2004

2005

2006

2007

interest rate differential Inflation rate differential

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Figure 6: IndonesiaJapan Inflation and Interest Rate Differentials
20 18 16 14 12 10 8 6 4 2 0

2003

2004

2005

2006

2007

Figure 7: IndonesiaSingapore Inflation and Interest Rate Differentials

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

interest rate differential Inflation rate differential

Figure 8: IndonesiaUK Inflation and Interest Rate Differentials

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

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.

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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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References
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Appendix
Regression Results
Table 1: Descriptive Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change
Mean S_IDRtoUSD i_INDtoUS .0006 .2824 Std. Deviation .03668 .29603

Table 2:

Correlations for Indonesia-US Interest Rate Differential and Exchange Rate Change
S_IDRtoUSD 1.000 .010 . .479 29 29 i_INDtoUS .010 1.000 .479 . 29 29

Pearson Correlation Sig. (1-tailed) N

S_IDRtoUSD i_INDtoUS S_IDRtoUSD i_INDtoUS S_IDRtoUSD i_INDtoUS

Table 3:

Anova for Indonesia-US Interest Rate Differential and Exchange Rate Change
Sum of Squares .000 .038 .038

Model 1

Regression Residual Total

Mean Square .000 .001

F .003

Sig. .957a

a. Predictors: (Constant), i_INDtoUS

Table 4:

Residual Statistics for Indonesia-US Interest Rate Differential and Exchange Rate Change
Minimum .0002 -.09741 -1.053 -2.608 Maximum .0017 .09651 2.901 2.584 Mean .0006 .00000 .000 .000 Std. Deviation .00038 .03668 1.000 .982

Predicted Value Residual Std. Predicted Value Std. Residual

Table 5:

Descriptive Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate Change
Mean Std. Deviation .0072 2.1516 .05111 .62860

S_IDRtoJPY i_INDtoJAP

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Table 6:

International Research Journal of Finance and Economics - Issue 26 (2009)

Correlations for Indonesia-Japan Interest Rate Differential and Exchange Rate Change
S_IDRtoJPY 1.000 -.366 . .025 29 29 i_INDtoJAP -.366 1.000 .025 . 29 29

Pearson Correlation Sig. (1-tailed) N

S_IDRtoJPY i_INDtoJAP S_IDRtoJPY i_INDtoJAP S_IDRtoJPY i_INDtoJAP

Table 7:

Anova for Indonesia-Japan Interest Rate Differential and Exchange Rate Change
Sum of Squares .010 .063 .073

Model 1

Regression Residual Total

Mean Square .010 .002

F 4.173

Sig. .050a

a. Predictors: (Constant), i_INDtoJAP

Table 8:

Residual Statistics for Indonesia-Japan Interest Rate Differential and Exchange Rate Change
Minimum -.0748 -.09649 -4.386 -1.992 Maximum .0257 .13537 .989 2.795 Mean .0072 .00000 .000 .000 Std. Deviation .01870 .04757 1.000 .982

Predicted Value Residual Std. Predicted Value Std. Residual

Table 9:

Descriptive Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change
Mean Std. Deviation .0133 .9921 .03646 .70953

S_IDRtoSGD i_INDtoSING

Table 10: Correlations for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change
S_IDRtoSGD 1.000 .026 . .447 29 29 i_INDtoSING .026 1.000 .447 . 29 29

Pearson Correlation Sig. (1-tailed) N

S_IDRtoSGD i_INDtoSING S_IDRtoSGD i_INDtoSING S_IDRtoSGD i_INDtoSING

International Research Journal of Finance and Economics - Issue 26 (2009)

Table 11: Anova for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change
Sum of Squares .000 .037 .037

168

Model 1

Regression Residual Total

Mean Square .000 .001

F .018

Sig. .894a

a. Predictors: (Constant), i_INDtoSING

Table 12: Residual Statistics for Indonesia-Singapore Interest Rate Differential and Exchange Rate Change
Minimum .0125 -.06454 -.855 -1.739 Maximum .0164 .12751 3.331 3.435 Mean .0133 .00000 .000 .000 Std. Deviation .00095 .03645 1.000 .982

Predicted Value Residual Std. Predicted Value Std. Residual

Table 13: Descriptive Statistics for Indonesia-UK Interest Rate Differential and Exchange Rate Change
Mean S_IDRtoGBP i_INDtoUK .0136 .9951 Std. Deviation .04391 .71327

Table 14: Correlations for Indonesia-UK Interest Rate Differential and Exchange Rate Change
S_IDRtoGBP 1.000 .299 . .058 29 29 i_INDtoUK .299 1.000 .058 . 29 29

Pearson Correlation Sig. (1-tailed) N

S_IDRtoGBP i_INDtoUK S_IDRtoGBP i_INDtoUK S_IDRtoGBP i_INDtoUK

Table 15: Anova for Indonesia-UK Interest Rate Differential and Exchange Rate Change
Sum of Squares .005 .049 .054

Model 1

Regression Residual Total

Mean Square .005 .002

F 2.652

Sig. .115a

a. Predictors: (Constant), i_INDtoUK

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Table 16: Residual Statistics for Indonesia-UK Interest Rate Differential and Exchange Rate Change
Minimum .0024 -.09204 -.854 -2.157 Maximum .0575 .14954 3.337 3.504 Mean .0136 .00000 .000 .000 Std. Deviation .01313 .04190 1.000 .982

Predicted Value Residual Std. Predicted Value Std. Residual

Table 17: Descriptive Statistics of Inflation Rate and Interest Rate Differential
Mean InterestRates InflationRates 2.2749 4.7820 Std. Deviation 1.09160 5.34761

Table 18: Correlations of Inflation Rate and Interest Rate Differential

InterestRates 1.000 .515 . .000 43 43 InflationRates .515 1.000 .000 . 43 43

Pearson Correlation Sig. (1-tailed) N

InterestRates InflationRates InterestRates InflationRates InterestRates InflationRates

Table 19: Anova of Inflation Rate and Interest Rate Differential

Sum of Squares 13.251 36.796 50.047

Model 1

Regression Residual Total

Mean Square 13.251 .897

F 14.765

Sig. .000a

a. Predictors: (Constant), InflationRates

Table 20: Residual Statistics of Inflation Rate and Interest Rate Differential
Minimum 1.8981 -2.07615 -.671 -2.192 Maximum 4.9938 2.32436 4.840 2.454 Mean 2.2749 .00000 .000 .000 Std. Deviation .56170 .93600 1.000 .988

Predicted Value Residual Std. Predicted Value Std. Residual