TSQ Discussion Paper

2001/02 – No.1

Relationship among Exchange Rate, Money Supply,

Interest Rate, and Prices Before and After Monetary Crisis

In Indonesia

- A Vector Autoregression Model Analysis -

June 2001

Shinji YOSHIOKA*
JICA-TSQ, BAPPENAS

* The author is a JICA (Japan International Cooperation Agency) Expert to BAPPENAS (National
Development Planning Agency of Indonesian Government) from CAO (Cabinet Office of Japanese
Government). But the opinions expressed in the paper are derived from the author’s study results and are
not the official views of JICA, BAPPENAS, CAO, or any government. The author is grateful to the
colleagues at BAPPENAS for their insightful feedback to this study and also thankful to Mr. Ramli
Ripai, BAPPENAS, for his assistance in data processing. The author’s contact point is
yoshioka@link.net.id.
Summary

In this paper, I employ a vector autoregression (VAR) model to analyze the relationship
among exchange rate, money supply, interest rate, and prices.

First, I identify data. I decide the data cut off data at December 1997 employing Chow
test. It means that Indonesian economic indicators employed here appear rather stable
until then. Seasonal adjustment of X-11 is applied to the data and Dickey-Fuller test is
examined for detecting a unit root. As a result, I employ the first order difference of
logarithmic series of relevant data from April 1990 to February 2001.

Second, I specify a VAR model employing Akaike Information Criterion (AIC) and
decide that the VAR model must contain four-term lag and an exogenous constant
term.

Third, I analyze this VAR model at three periods: 1) from September 1990 to June
1993, 2) from July 1994 to April 1997, and 3) from May 1998 to February 2001. I
employ impulse response function to a unit shock, forecast error variance
decomposition, and Granger causality to find out some empirical evidences.

Last, I state concluding remarks that although economic policy authorities operated
interest rate as the first policy instrument before the Asian monetary crisis, after it
money supply takes a place and at present we have to treat exchange rate as exogenous
because a large extent of forecast errors in money supply, interest rate, and prices is
originated from exchange rate.

JEL Classification Numbers: C32, C52, E37, E47, and F31

Key Word: VAR, Impulse Response, Forecast Error
Variance Decomposition, Granger Causality, Exchange
Rate, Inflation, Money Supply, Asia and Indonesia

1
1. Introduction

1.1 Main Purpose

In mid-1997, the monetary crisis in Asia was spread to Indonesia. Economic indicators,
especially exchange rate, prices, and those of monetary sector, fluctuated in a
skyrocket manner (see Chart 1). Some economic frameworks were also drastically
changed after the monetary crisis, e.g., Indonesia adopted floating foreign exchange
rate regime. During the monetary crisis, it appears that external shocks firstly
depreciated Indonesian Rupiah so much, then this depreciation inflated prices with
accommodating money supply, later the hike of prices and the currency depreciation
pulled up the interest rate, and finally, these high interest rates and prices depressed the
real economy in Indonesia together with consumers’ pessimistic future expectation 1.

Is this sequential understanding correct?

I prepare this paper directly to answer this question, employing a vector autoregression
(VAR) model for impulse response functions, forecast error variance decomposition 2,
and the causality relationship between exchange rate, money supply, interest rate, and
prices in Indonesia and also mainly to contribute to improve relevant sector of existing
models developed at BAPPENAS-JICA-TSQ. This paper focuses primarily on the
monetary sector, exchange rate and prices. This is partly because of data availability.
After the monetary crisis, we cannot take so many observations that monthly data are
adopted in this paper. But regrettably, monthly GDP data is not available at present.

At BAPPENAS, a lot of Japanese long-term experts have been dispatched from Japan
according to Japanese technical cooperation scheme, which is operated by Japan
International Cooperation Agency (JICA) and working for economic modeling analysis
from 1980’s. Mainly, these economic models have been employed for economic
forecast for Indonesian national planning exercises. After the monetary crisis, it is an
urgent task to improve specification of monetary sector, exchange rate, and prices in
economic modeling.

This paper consists of five chapters, including this introduction. This chapter develops
main purpose of this paper and some discussion about a VAR model. The second

1
Here, I intentionally omitted that the real national income reduced because of the deterioration of terms of trade
caused by currency depreciation.

2
chapter identifies data. Main discussion points are data cut off date before the crisis,
seasonal adjustment, and a unit root problem. Chow test and Dickey-Fuller test are
employed. The third chapter specifies a VAR model. Here, Akaike Information
Criterion (AIC) and Schwarz-Bayese Information Criterion (SBIC) are employed and
also Kullback-Leibler Information (KLI) is referred briefly. The fourth chapter is the
main part of this paper and reveals relationship among exchange rate, money supply,
interest rate, and prices. Impulse response functions to unit shocks and forecast error
variance decomposition are employed in a VAR model. Also VAR model analysis
reveals Granger causality among these four variables 3. At the final chapter, some
concluding remarks are stated briefly. For these analyses in this paper, Excel, TSP and
EViews 4 are employed as generic software for economic modeling. Sample programs
and relevant data are available as both a printed technical appendix and a zipped file 5.

1.2 Vector Autoregression (VAR) Model – What is VAR Model?

A vector autoregression (VAR) model is the unconstrained reduced form of a dynamic

simultaneous linear equations model. A VAR model approach never assumes any
structural economic model a priori. In a VAR model, it expresses a vector of
endogenous variables as linear functions of their own and each other’s lagged values. It
is theoretically possible to include contemporaneous value and/or lagged exogenous
variables but I exclude them for analysis in this paper. This style of simultaneous
equation modeling was introduced into econometrics by Sims (1980) and is now
widely employed for small- to medium-sized macroeconometric models, partially for
forecasting. VAR models are easily handled because the equations can be estimated by
the ordinary least square method. They are also employed, equally to usual regressive
analysis, for a comprehensive estimation of impact strength from a variable to another
and for explaining abilities among each other. And constrained VAR models are
adopted for Granger causality analysis. In this paper, VAR models are employed for the
estimation of impact strength with impulse response functions, for calculation of
explanatory degree of influence among variables on forecast errors with forecast error
variance decomposition, and for Granger causality analysis with constrained
estimations.

2
Impulse responses and forecast error variance decompositions are called innovation accounting.
3
Yoshioka (1998) and Yoshioka (1999) analyze Granger causality among relevant variables in those papers so that
I revisited this theme.
4
Excel is the trademark of Microsoft Corp., TSP is that of TSP International, and EViews is that of Quantitative
Study Method. I employ Excel 2000, TEP 4.5, and EViews 3.1 (V4.0 is not arrived to me) under operation system of
Windows 2000 Professional.
5
Please take contact with the author at yoshioka@link.net.id.

3
Here, a simple example of a VAR model that consists of two endogenous variables
with one-term lag and an exogenous constant term is shown below. Following equation
system is obtained when the first variable x1,t depends on contemporaneous value of
the second variable x2,t and previous (one-term lagged) value of its own and the second
variable x2,t depends on contemporaneous value of the first variable x1,t and previous
(one-term lagged) value of its own in the same manner. It is, off course, possible to
introduce other variables and expand lag terms.

(EQ1.1) x1,t=α10+α11x2,t+α12x1,t-1+e1,t
(EQ1.2) x2,t=α20+α21x1,t+α22x2,t-1+e2,t

The following VAR model system of (EQ1.3) and (EQ1.4) will be obtained,
substituting x1,t at (EQ1.1) to right hand of (EQ1.2) and contrariwise, x2,t at (EQ1.2) to
right hand of (EQ1.1).

(EQ1.3) x1,t=π10+π11x1,t-1+π12x2,t-1+ε1,t
(EQ1.4) x2,t=π20+π21x1,t-1+π22x2,t-1+ε2,t
where: π10=(α10+α11α20)/(1-α11α21)
π11=α12/(1-α11α21)
π12=α11α22/(1-α11α21)
ε1,t=e1,t/(1-α11α21)
π20=(α20+α21α10)/(1-α11α21)
π21=α22/(1-α11α21)
π22=α21α22/(1-α11α21)
ε2,t=e2,t/(1-α11α21)

Since a VAR model system is derived above transformation, it is called a reduced form.
Here, we have to pay a deep attention that a VAR model system would be apparently
instable when (1-α11α21) is equal to zero or (α11α21) is equal to one at a statistic
significance level. And also, a VAR process must be assumed in a stationary series. We
thus have to employ Dickey-Fuller test at the first chapter to avoid this problem.

In this paper, a VAR model system contains four variables, such as exchange rate,
money supply, interest rate, and prices, and is expressed as below:

(EQ1.5) Et = (C) +Σα1iEt-i +Σα2iMt-i + Σα3iRt-i + Σα4iPt-i

4
 (EQ1.6) Mt = (C) + Σβ1iEt-i+ Σβ2iMt-i + Σβ3iRt-i + Σβ4iPt-i
(EQ1.7) Rt = (C) + Σγ1iEt-i + Σγ2iMt-i+ Σγ3iRt-i + Σγ4iPt-i
(EQ1.8) Pt = (C) + Σδ1iEt-i + Σδ2iMt-i + Σδ3iRt-i + Σδ4iPt-i
where: E exchange rate
M money supply
R interest rate
P prices
(C) constant term 6
i lag term (=1, 2, ……, n)
α,β,γ,δ estimated parameters

We then go forward to identify the data.

6
It cannot be decided a priori to include or exclude constant terms. They are thus expressed with parenthesis.

5
 INDEX (1997 Apr. = 100)
1,000

200
400
600
800

0
Apr-90
Jul-90
Oct-90
Jan-91
Apr-91
Jul-91
Oct-91
Jan-92
Apr-92

Interest Rate
Exchange Rate
Jul-92
Oct-92
Jan-93
Apr-93
Jul-93
Oct-93
Jan-94
Apr-94

6
Jul-94
Oct-94
Jan-95
Chart 1

Apr-95
Jul-95
Oct-95
Jan-96
Apr-96
Jul-96
Oct-96
Jan-97
Apr-97
Jul-97
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Money Supply (M1)

Jul-99
Oct-99
Jan-00
Consumer Price Index

Apr-00
Jul-00
Oct-00
Jan-01
2. Data Identification

2.1 Data Cut Off Data

We can obtain some relevant data from Bank Indonesia (2000) for the analysis in this
paper. Exchange rate 7 over US Dollar, money supply of M1, interest rates of Bank
Indonesia Certificate for one month (SBI in Indonesian), and prices of consumer price
index are employed. Among them, CPI could not be obtained a single consistent series.
There are data available until March 1998 on a basis of index 1989 = 100, and after
April 1997, index 1996 = 100 series. It is required to combine these two CPI series into
a consistent series, which was completed with Excel VBA Macro program. After this
modification of CPI data, all of relevant data are available from April 1990 to February
2001.

The Asian monetary crisis began in mid-1997. This was spread to Indonesian economy
with some lags after its origin. Since we can obtain observations of only approximate
three years for examining some empirical analysis after the crisis, we have to employ
monthly data that are seasonally adjusted, instead of introducing seasonal dummy,
which means that we lose observations for approximate one year. For data
identification, we have to decide the data cut off date, which represents reliable data
length reflecting the rather stable Indonesian economy before the monetary crisis. It is
required for both data identification and VAR model system specification.

Here, we employ Chow test for answering the question until when the Indonesian
economy appeared stable. Chow test is employed for the stability of individual data in
this paper although usually regarded as a special form of F-test that checks the stability
of regression coefficients over two or more subsamples of the data. This is normally
completed for the whole sample period, and then running the same regression for
subsamples, and finally, comparing the sums of squared residuals (SSRs). The
regression for subsamples are expressed as followings when total observation number
is T and they are divided into T1 and T2 = T - T1, which means that until the T1th period
estimated coefficients are stable. The equation (EQ2.1) shows estimation for whole
sample period, (EQ2.2) does for subsample period until T1 - 1, and (EQ2.3) does for
subsample period after T1:

7
Before the monetary crisis, Indonesian exchange rate is strongly restricted. When estimating its movement, we
might not obtain market behavior but economic policy authorities’ behavior. But, even though it is, it might make

7
 (EQ2.1) y = const0 + α01x1 + α02x2 + …… + α0kxk + ε0
:t = T

(EQ2.2) y = const1 + α11x1 + α12x2 + …… + α1kxk + ε1

: t < T1

(EQ2.3) y = const2 + α21x1 + α22x2 + …… + α2kxk + ε2

: t ≧ T1

The first suffix of α indicates dataset number and the second does variable number.
We have to test following hypothesis for parameters stability:

(H2.1) const1 = const2, α11 =α21, α12 =α22, ……, α1k =α2k

Actual F-test will be completed for following F statistic:

SSRT − ( SSR1 + SSR2 )

SSR1 + SSR2
(EQ2.4) Chow =
T − 2k
k
where: SSRT sums of squared residuals for whole sample period
SSR1 sums of squared residuals until T1 - 1 period
SSR2 sums of squared residuals after T1 period
T number of observations
k number of parameters ( i.e., independent variables)

This F-statistic Chow is subject to F(k, T-2k). Table 1 and Chart 2 report results of
Chow test employing simple time trends regression.

A deep attention has to be paid that since the Indonesian economy experienced a
drastic fluctuation after the Asian monetary crisis, which is reported at Chart 1, almost
every Chow test result indicates statistical significance. At Table 1 and Chart 2, all
F-statistics are significant at 1 percent level. Among them, we have to pick up the
highest F-statistics. We can then observe some different cut off date from the results.
For exchange rate, the data until December 1997 appear stable, for money supply until
November, and for both interest rate and prices, until March 1998. Among these
candidates of cut off dates, I employ December 1998. This is mainly because it appears
the representative of average for these data, and partly because December is a good

sense to estimate economic policy authorities’ behavior to some extent.

8
timing to cut off.

9
Table 1 Results of Chow Test
Unit: F-Statistics
Exchange Money Interest Rate Prices
Rate Supply
1996 Dec. / 1997 Jan. 46.6372 355.697 11.7168 197.847
1997 Jan. / 1997 Feb. 48.7111 347.293 13.4818 198.133
1997 Feb. / 1997 Mar. 51.4749 341.205 15.6991 198.768
1997 Mar. / 1997 Apr. 55.1586 338.792 18.5799 200.369
1997 Apr. / 1997 May 60.1054 336.614 22.2594 202.913
1997 May / 1997 Jun. 66.8747 335.791 26.9415 207.274
1997 Jun. / 1997 Jul. 76.3383 326.485 33.0486 214.605
1997 Jul. / 1997 Aug. 89.0614 322.270 40.9522 225.584
1997 Aug. / 1997 Sep. 104.171 335.149 49.7026 241.914
1997 Sep. / 1997 Oct. 124.456 354.081 54.3941 266.385
1997 Oct. / 1997 Nov. 150.31 381.990 61.6963 303.779
1997 Nov. / 1997 Dec. 195.000 413.838 72.2216 367.639
1997 Dec. / 1998 Jan. 238.430 399.469 86.8363 484.963
1998 Jan. / 1998 Feb. 133.449 310.195 108.199 659.615
1998 Feb. / 1998 Mar. 101.581 256.656 135.949 746.794
1998 Mar. / 1998 Apr. 83.8169 206.604 158.342 779.945
1998 Apr. / 1998 May 73.3011 178.830 125.543 745.717
1998 May / 1998 Jun. 51.6037 147.024 83.8410 635.281
1998 Jun. / 1998 Jul. 25.6385 120.714 59.1489 503.432
1998 Jul. / 1998 Aug. 14.8968 105.564 36.2200 341.020
1998 Aug. / 1998 Sep. 9.95855 95.1821 23.0556 225.749
1998 Sep. / 1998 Oct. 6.76604 88.1189 15.6361 155.442
1998 Oct. / 1998 Nov. 6.10396 83.5492 12.3509 116.562
1998 Nov./1998 Dec. 5.66572 79.3016 11.1286 91.6224
Source: Author’s Estimation

10
 F Statistics F Statistics
19 19
96 96

(2) Money Supply

(1) Exchange Rate

19 De 19 De

0
50
100
150
200
250
300
350
400
450
0
50
100
150
200
97 c. 97 c. 250
19 Fe 19 Fe
97 b. 97 b.
19 19
Chart 2 Results of Chow Test

Ap Ap
97 r. 97 r.
19 Ju 19 Ju
97 n. 97 n.
19 Au 19 Au
97 g. 97 g.
19 Oc 19 Oc
97

11
t. 97 t.
19 De 19 De
98 c. 98 c.
19 Fe 19 Fe
98 b. 98 b.
19 Ap 19 Ap
98 r. 98 r.
19 Ju 19 Ju
98 n. 98 n.
19 Au 19 Au
98 g. 98 g.
Oc Oc
t. t.
 F Statistics F Statistics

(4) Prices
19 19
(3) Interest Rate

96 96
19 De 19 De

0
100
200
300
400
500
600
700
800
900
0
20
40
60
80
100
120
140
160
180

97 c. 97 c.
19 Fe 19 Fe
97 b. 97 b.
19 Ap 19 Ap
97 r. 97 r.
19 Ju 19 Ju
97 n. 97 n.
19 Au 19 Au
97 g. 97 g.
19 Oc 19 Oc
97 97

12
t. t.
19 De 19 De
98 c. 98 c.
19 Fe 19 Fe
98 b. 98 b.
19 Ap 19 Ap
98 r. 98 r.
19 Ju 19 Ju
98 n. 98 n.
19 Au 19 Au
98 g. 98 g.
Oc Oc
t. t.
After deciding the cut of date, a seasonal adjustment has to be introduced not to lose
observations. Here, X-11 system of US Census Bureau is employed. This program is
implemented in EViews. Although X-12-ARIMA system is already provided at FTP
site of the entity, it is not applicable so far. According to the cut off date, X-11 runs for
seasonal adjust for data from April 1990 to December 1997. Seasonal adjusting
coefficients in 1997 are adopted for the rest of data, such as years 1998, 1999, 2000,
and 2001.

Now all of relevant data are available for the analysis in this paper.

2.2 Unit Root

It is well known that the data with time trend contains a unit root. In this paper, I
employ exchange rate, money supply, interest rate, and prices. These variables except
interest rate usually seem to have an upward time trend in Indonesia. Although in some
developed countries, exchange rate appears rather stable with some possible
fluctuation, Indonesian exchange rate apparently includes some strong upward time
trends. According to discussion at the first chapter, we have to avoid the risk of unit
root when analyzing a VAR model. For this purpose, Dickey-Fuller test is employed.

To understand Dickey-Fuller test, the following model is useful:

(EQ2.5) yt= α+ βTimeTrend + ut

(EQ2.6) ut = γut-1 + εt

Here, εt is the stational covariant process with zero average. This model of (EQ2.5)
and (EQ2.6) is reduced to following one:

(EQ2.7) yt = δ + θTimeTrend + γyt-1 +εt

where: δ = α(1 - γ) + βγ
θ = β(1 - γ)

When γ = 1, e.g., θ = 0, then this model contains a unit root. The null hypothesis
should be then following:

(H2.2) γ = 1 (or θ = 0)

13
Dickey-Fuller test is based on testing the above hypothesis whileεt is assumed to be a
white noise error. We obtain following three statistic values:

(EQ2.8) K(1) = T(π-1)

π −1
(EQ2.9) t (1) =
SE (π )
(EQ2.10) F(0,1)

Here, π is an ordinary least square (OLS) estimator, SE(π) is a standard error of π,

and F(0,1) is normal F-statistics to test the combined hypothesis ofγ = 1 and θ = 0.
It is already revealed that these are not subject to the standard normal distribution, the t
distribution or the F distribution. Collected distribution table are thus provided in
Fuller (1976) and Dickey-Fuller (1980).

Based on this Dickey-Fuller test, Table 2 reports the results of four series, which are
the original seasonal adjusted, the logarithmic, the first differential, and the first order
differential logarithmic series. Sims (1980) recommends to employ (1 - 0.75log(xt))2 =
1 - 1.5log(xt) + 0.5625log(xt-1) because empirically, it could be obtained appropriate
series for his analysis. But apparently, what kind of transformation should be employed
depends on various economic situations and the purpose of analysis. Here, I pick up
some more common series reported above Table 2.

Table 2: Results of Dickey-Fuller Test

Unit: Probability for Lower Tail Area
Exchange Money Interest Prices
Rate Supply Rate
Original Seasonal Adjusted Series 1.0000 .92822 .93947 .99636
Logarithmic Series 1.0000 .10127 .96061 .29166
First Order Differential Series .02224 .00000 .00000 .00001
First Order Differential Logarithmic Series .00842 .00000 .00000 .00000
Source: Author’s Estimation

The figures at Table 2 indicate risk for rejecting the null hypothesis (H2.2), which is
called lower tail area probability. Thus, the more this figure is, the more risk exists. For
both original seasonal adjusted and logarithmic series, all of variables appear to
contain unit roots. They are not appropriate for a VAR model. For the first differential
series of exchange rate, the null hypothesis (H2.2) cannot be rejected at 1 percent
significance while the first differential logarithmic series is able to reject it. It thus

14
appears that we have to employ the first differential logarithmic series for the VAR
model analysis.

Now we are ready to go forward to VAR model specification.

15
3. Vector Autoregression (VAR) Model Specification

3.1 Akaike Information Criterion

Since we already discussed at the chapter 1, it is required to decide how long the lag
length is and whether a constant term is included. Usually, for evaluating regression
results, many economists employ the coefficient of determination (R-square) or the
coefficient of determination adjusted for degree of freedom (Adjusted R-square). On
the other hand, it is well known that these statistic values do not indicate enough
penalties for increasing dependent variables. Employing a VAR model, increasing
dependent variables is equal to lengthen lag term. We thus employ another evaluating
standard.

Here, I employ Akaike Information Criterion (AIC), which is introduced into

econometrics by Akaike (1971) and Akaike (1973), based on likelihood ratio test 8, and
widely accepted as a generic criterion for a model specification. It is formulated as
following 9:

(EQ3.1) AIC = -2LML + 2k

where: LML log of maximum likelihood
k number of parameters in a model

At the same time, Schwarz Bayse Information Criterion (SBIC) is also widely utilized
for a model specification, which is based on an ex post facto probability of Baysian
statistics. It is formulated as following:

(EQ3.2) SBIC = -2LML + klog(n)

where: LML log of maximum likelihood
k number of parameters in a model
n number of observations

8
Appendix for Chapter 3 develops a brief discussion about most likelihood method.
9
In some textbooks of econometrics like Maddala (1992), the formulation of AIC is calculated, normalized with
number of observations and expressed as
− 2 LML 2k
AIC = +
n n
And also according to Hall and Cummins (1999), TSP Version 4.4 or earlier was also calculating it normalized with
number of observations equal to Maddala’s formulation. But TSP 4.5 now calculates with (EQ3.1). But practically,
these two formulations of AIC differ only at the constant term and they do not have any difference or inconsistency
for the model specification.

16
I introduced two criteria but AIC is more widely accepted and applicable for all models
that can be estimated by the most likelihood method. And AIC appears more generic
than SBIC does. Since AIC indicates the gap between the most desirable model and the
actually tested model, the smaller AIC is, the better the actually tested model is. The
model with the smallest AIC should be specified.

Table 3 reports AIC and SBIC. According to AIC, a VAR model with a constant term
and four-lag terms shows the best statistics to be employed, and according to SBIC, a
model with two-lag terms does. Although I estimated SBIC, here, we should specify a
VAR model according to AIC. This is because AIC is consistent with a basic
econometric theory and Kullback-Laibler Information (KLI).

Table 3: Akaike Information Criterion and Schwarz-Bayese Information Criterion

Unit: none
Lag Term in VAR Model Constant Term Included Constant Term Excluded
AIC SBIC AIC SBIC
1 -815.871 -791.328 -796.827 -796.827
2 -865.474 -821.296 -853.675 -814.406
3 -866.528 -802.715 -857.380 -798.476
4 -872.009 -788.561 -866.192 -787.653
5 -870.969 -767.886 -868.352 -770.178
6 -871.807 -749.090 -868.837 -751.028
Source: Author

3.2 Kullback-Leibler Information

Kullback-Leibler Information (KLI) is a very useful concept for understanding theory

of AIC. KLI indicates the gap between the true model and the actually tested model,
which is same as AIC. KLI is expressed as following:

(EQ3.3) KLI = E [LML(g / f)]

where: E average (expectation value)
LML log of maximum likelihood
g true model
f actually tested model

17
Here, although g is unknown and, off course, impossible to be estimated, it depends
only on the true model and we can treat it as constant. To minimize KLI thus is equal
to maximize E [LML(g / f)]. When f is a model depends on some parameters as equal to
a multiple regression model and is included among them, it could be replaced by log of
maximum likelihood divided with number of observations, as follows:

(EQ3.4) h = LML(f) / n
where: n number of observations

Although the statistics h at (EQ3.4) has a bias, we can calculate it approximately as

following:

(EQ3.5) E [LML(f)] = (LML(f) - k) / n

where: E average (expectation value)
k unknown number of parameters in a model
n number of observations

Apparently, we can obtain AIC as (EQ3.5) multiplied by -2n. AIC is thus consistent
with this KLI.

(Appendix to Chapter 3)
Maximum Likelihood Method

Both AIC and KLI are based on and employ the maximum likelihood method. It is well
known that the most likelihood estimator has some desirable features. It is an identical
estimator and its variance could be minimized, and a function substituted by the most
likelihood estimator is also regarded as the most likelihood estimator. But it is not a
necessarily an unbiased estimator.

Usually, when regressing y with x, an ordinary square estimator is obtained by the

following equation (EQ3.6) while maximum likelihood method solves its estimator
iteratively by (EQ3.7):

(EQ3.6) y = α0 + α2x + ε
(EQ3.7) y = β0 + β1x + β2(y-1 – β0– β1x-1) + ε

The maximum likelihood estimator and the ordinary least square estimator at the

18
estimation of regressive parameters are equal when following assumptions on an error
term are satisfied:

(EQ3.8) E(εt) = 0
Average is zero.
(EQ3.9) var(εt) = σ2
Homoschedasticity (i.e.,No heteroschedasticity).
(EQ3.10) E(εtεt-s) = 0 when s ≠ 0
No serial correlation.
(EQ3.11) E(εt (xt-E(xt))) = 0
No correlation with independent variables.
1 1
(EQ3.12) ε t ～f (ε t ) = exp(− 2 ε t )
2

2πσ 2σ
Subject to a normal distribution.

When parameters in a regressive equation are estimated by the most likelihood method,
we usually assume the equation (EQ3.6). But here, I change some expressions to avoid
possible confusion:

(EQ3.13) yt = α + βxt + εt

εt is subject to a normal distribution as of (EQ3.12). Then, the probability (likelihood)

that “n” observations realize simultaneously, εt = yt – α – βxt (t = 1, 2, …, n) is
given by following likelihood function:

(EQ3.14) L(α, β|x1, x2, …… , xn, y1, y2, …… , yn)

= f(ε1) f(ε2) …… f(εn)
1 1 n 2
=
( 2π ) n σ n
exp( − ∑εt )
2σ 2 t =1

To maximize this likelihood function, we have to minimize a part of above equation

(EQ3.14) on α and β as expressed below:

n n

∑ε = ∑ ( y t − α − βxt ) 2
2
(EQ3.15) t
t =1 t =1

Apparently, the estimator obtained by this methodology is totally equal to that by the

19
ordinary least square. But practically, since mostly maximum likelihood method will
be employed for avoiding a serial correlation problem at error terms, the assumption
(EQ3.10) is not usually satisfied.

20
4. VAR Model Estimation Results and Causality Analysis

At this chapter, I examine a VAR model estimation with variables of exchange rate,
money supply, interest rate, and prices and four-term lag and an exogenous constant
term: its general form is reported at the first chapter as (EQ1.5), (EQ1.6), (EQ1.7), and
(EQ1.8). Here, I employ three different estimation periods: 1) from September 1990 to
June 1993, 2) from July 1994 to April 1997, and 3) from May 1998 to February 2001.
This division of period is mainly because of data availability. First, I employ the last
period from May 1998 to February 2001 as a sample period of the post crisis and
second, pick up one from September 1990 to June as the earliest period from data
availability, and third, I do from July 1994 to April 1997 as an intermediate period of
these two. According to this division, I examine a VAR model analysis for an impulse
response function, forecast error variance decomposition, and Granger causality.

Although an impulse response function and a forecast error variance decomposition

appear quite similar, it must be paid a deep attention that the former indicates a
repercussive response among endogenous variables when external shock is given to a
specific variable and the latter does degree of influence on forecast errors without any
external shocks in a forward looking manner. But practically, these two are dealt with
almost same so that one of these could be represent for the purpose of analysis while
this paper deals with both.

4.1 Impulse Response Function to Unit Shock

As known well, the simplest autoregression model without a constant term could be
expressed with a lag operator and its error terms as following:.

(EQ4.1) xt = α1xt-1 + α2xt-2 + α3xt-3 + …… + αkxt-k + εt

or
(EQ4.2) xt = (α1L + α2L2 + α3L3 + …… + αkLk)xt+ εt
or
(EQ4.3) (1 -α1L - α2L2 - α3L3 - …… - αkLk)xt =εt
or
1
(EQ4.4) xt = εt
1 − α 1 L − α 2 L − α 3 L3 −  − α k Lk
2

where: L lag operator, e.g., Ln(xt) = xt-n

21
Equally, this is adoptable to a VAR model, which is a special form of an autoregression
model. The transformation is following:

(EQ4.5) x1,t = α11x1,t-1 + α12x2,t-1 + ε1,t

(EQ4.6) x2,t = α21x1,t-1 + α22x2,t-1 + ε2,t

(EQ4.5) and (EQ4.6) can be transformed to following matrix with lag operators:

1 − α 11 L − α 12 L   x1,t  ε 1,t 
(EQ4.7)  − α L 1 − α L   x  = ε 
 21 22   2 ,t   2 ,t 

(EQ4.7) can be solved as following:

−1
 x1,t  1 − α 11 L − α 12 L  ε 1,t 
(EQ4.8)  =   
 x 2,t   − α 21 L 1 − α 22 L  ε 2,t 
or

 x1,t  1 1 − α 22 L α 12 L  ε 1,t 
 =   
1 − α 11 L  ε 2,t 
(EQ4.9)
 x 2,t  ∆  α 21 L
where: Δ = (1 - α11L)(1 - α22L) -α12Lα21L
= 1 - (α11 + α22)L + (α11α22 -α12α21)L2
= (1 - λ1L)(1 - λ2L)

Here, λ1 and λ2 are roots of following equation:

(EQ4.10) λ2 - (α11 + α22)λ+ (α11α22 -α12α21) = 0

Apparently, x1,t and x2,t can be expressed with contemporaneous and lagged ε1,t and
ε 2,t. This is well-known as an impulse response function, which indicates the
influence to x1,t and x2,t from ε 1,t and ε 2,t when an external shock is given.
Employing a VAR model, it is easily calculated. Practically, an impulse response
function shows an influence degree from a certain variable to another variables. Table
4 and Chart 3 report this impulse response functions to unit shocks.

22
Table 4: Impulse response Functions to Unit Shocks
Unit: none
Shock to Exchange Rate (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 1.00000 0.00000 0.00000 0.00000
2 -0.58627 0.0044241 0.0047612 -0.16041
3 0.47463 -0.015077 0.0010552 0.10229
4 0.17516 -0.0057388 0.0043627 0.044106
5 -0.046310 -0.0098253 -0.0016707 0.018928
6 0.26210 0.013105 0.0023030 0.096813
Shock to Money Supply (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 1.00000 0.00000 0.00000
2 2.06241 -0.81878 0.049550 -0.26877
3 -0.24370 0.25601 -0.10163 1.35146
4 -2.28712 -0.076267 -0.0074947 -1.12579
5 1.09781 0.19934 -0.016003 1.36733
6 1.45031 -0.34316 0.046323 -0.098361
Shock to Interest Rate (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 1.00000 0.00000
2 -0.16319 0.61857 -0.32985 -1.12584
3 6.17952 -0.77940 -0.088310 1.10994
4 4.73275 -0.088593 0.14050 0.090154
5 -1.62044 0.32543 -0.072169 0.77332
6 2.06521 -0.31853 0.11822 1.79686
Shock to Prices (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 0.00000 1.00000
2 -0.26335 -0.074366 0.022515 0.41818
3 -0.0092563 0.077698 -0.011610 0.21092
4 0.17148 -0.018787 -0.011541 -0.032163
5 -0.57423 -0.033221 0.023996 -0.13678
6 -0.0023009 0.040021 -0.0085167 -0.15506
Shock to Exchange Rate (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 1.00000 0.00000 0.00000 0.00000
2 0.34116 -0.067072 -0.051032 0.41647
3 0.19793 -0.0029164 -0.0039273 0.26352
4 0.22465 0.072340 0.0085398 0.41067
5 -0.42412 0.059407 0.0096852 0.32191
6 -0.21989 -0.055094 0.032313 -0.23403
Shock to Money Supply (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 1.00000 0.00000 0.00000
2 -0.44025 -0.42981 0.16041 -1.17167
3 1.21838 -0.17366 -0.20541 1.96952
4 -0.73729 -0.31226 -0.17966 -0.99064
5 -0.50287 0.52918 0.12320 -0.44243
6 0.43301 -0.010243 0.17728 0.43856

23
Shock to Interest Rate (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 1.00000 0.00000
2 1.07042 0.67037 0.91306 1.02305
3 -0.99434 0.42122 1.01087 1.81081
4 0.40995 0.73232 0.91085 0.41619
5 0.085369 0.80238 0.93236 1.23296
6 -0.074728 0.70349 0.76368 0.76715
Shock to Prices (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 0.00000 1.00000
2 0.023565 -0.082434 -0.028884 0.047341
3 -0.095507 -0.022780 0.078851 -0.045127
4 0.12413 0.047967 0.11328 0.024636
5 0.0096101 0.059992 0.033726 0.068854
6 -0.069634 0.018492 0.035564 -0.083268
Shock to Exchange Rate (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 1.00000 0.00000 0.00000 0.00000
2 -0.15168 0.50000 0.36002 0.67243
3 -0.44810 1.65088 0.63711 -2.33912
4 -0.072834 0.17165 -0.077227 -3.46991
5 -0.050919 -0.49430 -0.10606 2.75987
6 -0.015000 -0.60996 0.046910 -0.097416
Shock to Money Supply (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 1.00000 0.00000 0.00000
2 0.078032 -0.41857 0.21356 -0.95309
3 0.021370 0.057516 -0.016871 -0.12544
4 -0.14745 0.31253 -0.039454 -0.22428
5 0.010908 -0.036531 0.045121 0.61000
6 0.036636 -0.42364 -0.035045 -0.69386
Shock to Interest Rate (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 1.00000 0.00000
2 0.22017 0.32545 0.78764 -2.57144
3 0.19007 0.60057 0.45054 2.59669
4 -0.12537 0.67219 0.54219 1.43706
5 -0.18478 0.77774 0.23558 -1.58299
6 -0.094573 0.25882 -0.094935 -2.98778
Shock to Prices (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.00000 0.00000 0.00000 1.00000
2 0.039264 -0.030234 0.025353 0.43415
3 0.035276 0.099478 0.0013195 0.10609
4 -0.00030867 0.18530 0.036412 -0.28611
5 -0.012489 0.18911 0.064879 -0.10025
6 0.0014626 0.011037 0.064652 -0.084185
Source: Author’s Estimation

24
Chart 3. Impulse Responses

Period: Sep.1990 - Jun. 1993

E to E M to E R to E P to E

7 7 7 7

6 6 6 6

5 5 5 5

4 4 4 4

3 3 3 3

2 2 2 2

1 1 1 1

0 0 0 0
1 2 3 4 5 6
1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-1 -1 -1 -1

-2 -2 -2 -2

-3 -3 -3 -3

E to M M to M R to M P to M
1.5
1.5
1.5 1.5

1.0
1.0 1.0 1.0

0.5
0.5 0.5 0.5

0.0
0.0 0.0 0.0
1 2 3 4 5 6
1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-0.5
-0.5 -0.5 -0.5

-1.0
-1.0 -1.0 -1.0

E to R M to R R to R P to R
1.0
1.0 1.0 1.0

0.5 0.5 0.5 0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

E to P M to P R to P P to P
2.0
2.0 2.0
2.0

1.5
1.5 1.5
1.5

1.0 1.0 1.0

1.0

0.5 0.5 0.5

0.5

0.0 0.0 0.0

0.0
1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

-1.0 -1.0 -1.0

-1.0

-1.5 -1.5 -1.5

-1.5

25
Chart 3. Impulse Responses

Period: Jul. 1994 - Apr. 1997

E to E M to E R to E P to E
1.5 1.5 1.5
1.5

1.0 1.0 1.0

1.0

0.5 0.5 0.5 0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

-1.0 -1.0 -1.0 -1.0

E to M M to M R to M P to M
1.0 1.0 1.0 1.0

0.5 0.5 0.5 0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

-1.0 -1.0 -1.0 -1.0

E to R M to R R to R P to R

1.25 1.25
1.25 1.25

1.00 1.00
1.00 1.00

0.75 0.75
0.75 0.75

0.50 0.50
0.50 0.50

0.25 0.25 0.25 0.25

0.00 0.00 0.00 0.00

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-0.25 -0.25 -0.25 -0.25

E to P M to P R to P P to P

2.5 2.5 2.5

2.5

2.0 2.0 2.0

2.0

1.5 1.5 1.5

1.5

1.0 1.0 1.0

1.0

0.5 0.5 0.5 0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

-1.0 -1.0 -1.0 -1.0

-1.5 -1.5 -1.5

-1.5

26
Chart 3. Impulse Responses

Period: May 1998 - Feb. 2001

E to E M to E R to E P to E
1.0 1.0
1.0 1.0

0.5 0.5 0.5

0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6
1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

E to M M to M R to M P to M
2.0
2.0 2.0 2.0

1.5
1.5 1.5 1.5

1.0 1.0
1.0 1.0

0.5 0.5 0.5

0.5

0.0 0.0 0.0 0.0

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-0.5 -0.5 -0.5 -0.5

-1.0 -1.0
-1.0 -1.0

E to R M to R R to R P to R

1.00 1.00
1.00 1.00

0.75 0.75
0.75 0.75

0.50 0.50 0.50

0.50

0.25 0.25 0.25 0.25

0.00 0.00 0.00 0.00

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6

-0.25 -0.25 -0.25 -0.25

E to P M to P R to P P to P

4 4 4 4

3 3 3 3

2 2 2 2

1 1 1 1

0 0 0 0
1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4 5 6
1 2 3 4 5 6

-1 -1 -1 -1

-2 -2 -2 -2

-3 -3 -3 -3

-4 -4 -4
-4

27
From Table 4 and Chart3, we can point out some feature of relationship among these
four variables as following. But a deep attention has to be paid that the variables
employed here, except for prices, are observed at so strongly restricted markets that the
responses might not be those of markets but of policy authorities’ behavior and/or
response.

First, we can point out a strongly convergent tendency against own shocks. Own
shocks, e.g., exchange rate to exchange rate, money supply to money supply, interest
rate to interest rate, and prices to prices, are quickly absorbed in a few months except
the interest rate case at period from July 1994 to April 1997. But the only exceptional
case also shows rather convergent tendency and never does divergent one. In this
meaning, Indonesian economy is rather stable even after the monetary crisis.

Second, before the crisis, interest rate has a strong influence to another variables.
Especially, money supply seems to be managed in an accommodating manner against
interest rate. But, here, so-called price puzzle is observed, which is prices’ positive
reaction against interest or money supply shocks 10. Also this price puzzle is observed
against exchange rate after the crisis. This leading role of interest rate is anyway
switched to exchange rate after the crisis.

Third, we can observe different reflection of money supply, interest rate, and prices
against exchange rate shocks before and after the crisis. The results of the first two
periods, e.g., that from September 1990 to June 1993 and that from July 1994 to April
1997, reveal very little influences from exchange rate to another variables. On contrary,
after the crisis, exchange rate shocks have rather strong influences to another variables.

Fourth, concerning to money supply and prices, money supply’s influence power at the
previous two periods is also replaced by exchange rate after the crisis. Money supply
seems to be managed against interest rate in a accommodating manner before the crisis
while prices has very little influence to all variables.

4.2 Forecast Error Variance Decomposition

As shown in (EQ4.1), (EQ4.2), (EQ4.3), and (EQ4.4), the simplest autoregression

model can be expressed with a lag operator and an error term. The forecasted value of
xt+n at forward nth term then can be expressed sum of forecasted value at tth term and a
10
This is also discussed at Christiano et al. (1998).

28
forecast error as following:

(EQ4.11) xt+n = fxt(n) + εt(n)

where: fxt(n) forecasted value of x at tth term
εt(n) forecast error

Here, this equation is also expressed as following:

(EQ4.12) fxt(n) = E[xt+n]

where: E average (expectation value)

Off course, εt(n) is assumed to be a white noise, so: E[εt(n)] = 0. And the variance
of an error term is expressed with coefficients of regression and variance of the first
order error term as following:

(EQ4.13) var[εt(n)] = E[εt2(n)] = (1 + α12 + α22 + … + αkk)σ2

where: σ2 = var[εt(1)]
E average (expectation value)

Decomposing this forecast error variance, we can obtain degree of influence on

forecast errors to a certain variable from another variables. Table 5 and Chart4 report
forecast error variance decomposition of the VAR model 11.

11
For his purpose, here, a shock of Choleski factorization is given to the VAR model, instead of a unit shock.

29
Table 5: Forecast Error Variance Decomposition
Unit: percent
Forecasting Exchange Rate (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 100.00000 0.00000 0.00000 0.00000
2 84.77247 1.41285 0.026196 13.78849
3 78.37531 4.84297 0.48290 16.29882
4 76.88759 5.22246 1.17447 16.71548
5 75.98343 6.24914 1.17404 16.59340
6 72.69166 6.59694 1.68859 19.02281
Forecasting Money Supply (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 5.52443 94.47557 0.00000 0.00000
2 3.55299 96.07905 0.18349 0.18447
3 3.32652 91.68405 0.47106 4.51837
4 4.08085 88.00045 0.69199 7.22671
5 4.09276 84.27489 0.76363 10.86872
6 3.87557 84.93975 0.89085 10.29384
Forecasting Interest Rate (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 7.25892 0.17091 92.57016 0.00000
2 8.70630 13.87346 75.56080 1.85944
3 8.54881 28.93309 59.63032 2.88778
4 10.17653 28.20545 58.81152 2.80649
5 9.94633 29.49281 57.18677 3.37408
6 9.21871 30.37896 54.07730 6.32503
Forecasting Prices (Estimation Period: Sep. 1990 – Jun. 1993)
Lag Exchange Rate Money Supply Interest Rate Prices
1 4.86692 2.81706 5.16067 87.15535
2 9.52478 12.70025 7.39038 70.38459
3 8.89110 17.56186 6.79281 66.75423
4 9.04822 17.77749 7.11232 66.06198
5 11.85301 17.54168 7.52542 63.07989
6 11.80441 19.06002 7.63695 61.49862
Forecasting Exchange Rate (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 100.00000 0.00000 0.00000 0.00000
2 87.07125 1.86068 2.59641 8.47166
3 84.67596 1.75663 2.46049 11.10692
4 76.77520 4.47262 2.18642 16.56575
5 75.29937 5.35385 1.87365 17.47314
6 71.81486 7.78195 2.40805 17.99514
Forecasting Money Supply (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 4.38334 95.61666 0.00000 0.00000
2 3.44408 89.25529 2.00179 5.29884
3 11.87854 68.53844 4.11716 15.46587
4 12.28308 65.48820 5.25707 16.97166
5 13.59172 66.09088 5.21518 15.10222
6 13.95566 64.64544 6.30359 15.09531

30
Forecasting Interest Rate (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.010264 22.21627 77.77347 0.00000
2 1.63936 14.22518 81.53359 2.60187
3 4.36881 9.48391 79.37600 6.77129
4 3.49900 8.97447 81.90584 5.62068
5 3.10338 8.90160 81.90204 6.09298
6 3.13095 9.27283 81.68202 5.91420
Forecasting Prices (Estimation Period: Jul. 1994 – Apr. 1997)
Lag Exchange Rate Money Supply Interest Rate Prices
1 0.34940 0.28919 0.11011 99.25130
2 1.32403 7.84096 1.47475 89.36026
3 1.81961 12.35879 9.81250 76.00910
4 2.39347 10.58248 22.96475 64.05930
5 2.39580 12.15143 23.37191 62.08086
6 3.01283 11.84695 24.20269 60.93753
Forecasting Exchange Rate (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 100.00000 0.00000 0.00000 0.00000
2 93.10452 0.67524 6.02565 0.19460
3 77.95304 8.61459 11.31500 2.11738
4 72.64257 7.93903 13.51862 5.89977
5 70.54865 8.12640 13.25538 8.06957
6 69.05818 10.12923 12.95021 7.86237
Forecasting Money Supply (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 14.25448 85.74552 0.00000 0.00000
2 14.41089 77.14703 5.46855 2.97353
3 14.61639 76.76926 5.61280 3.00155
4 21.82766 70.02697 5.46938 2.67599
5 21.55459 67.75738 7.11351 3.57452
6 19.73288 68.10143 7.83910 4.32659
Forecasting Interest Rate (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 18.58113 6.38546 75.03342 0.00000
2 34.80912 4.37368 57.43683 3.38037
3 38.59166 4.19799 52.44563 4.76472
4 34.62133 4.44809 56.17429 4.75629
5 33.76116 5.93319 54.93195 5.37370
6 32.74067 5.73755 53.96414 7.55763
Forecasting Prices (Estimation Period: May 1998 – Feb. 2001)
Lag Exchange Rate Money Supply Interest Rate Prices
1 2.15391 2.28718 30.56588 64.99303
2 21.73296 1.88059 29.55124 46.83521
3 32.61009 7.18169 23.29407 36.91415
4 31.64081 15.82915 19.80255 32.72748
5 29.83651 20.65059 22.18338 27.32952
6 29.42071 19.39004 25.90706 25.28219
Source: Author’s Estimation

31
32
33
34
From Table 5 and Chart4, we can point out some feature of relationship among these
four variables as following. Different from impulse response functions, analysis of
forecast error variance decomposition reveals degree of influence on forecast errors
directly derived from a VAR model without any external shocks. The forecasted
variable itself is thus the most influential.

First, we have to point out that exchange rate explains errors at another variables after
the crisis to a sizable degree, comparing with that at the first two periods. This result is
consistent with that derived from impulse response functions mentioned above. It may
imply that many variables might be misestimated if exchange rate is wrongly
forecasted. At the final concluding remarks, since I will revisit this point, at a
macroeconomic modeling framework, exchange rate must be treated as exogenous and
it is strongly recommended to examine some alternative simulations on different
assumptions of exchange rate, instead of endogenizing it.

Second, at the first two periods, exchange rate forecast error is under prices influence
to a sizable extent. This may suggest that the purchase power parity hypothesis is
dominant for Indonesian exchange rate. But at the third period, interest rate is powerful
for forecast error of exchange rate, comparing with the former two periods.

Third, also at the first two periods, prices have sizable explaining ability for money
supply. But, here, at the final period, interest rate also occupy the dominant position.
These two facts suggest that after the crisis, economic variables get more sensitive for
interest rate. In other words, importance of interest rate now gets more than before the
crisis.

Fourth, money supply error is under prices influence at the first two periods. Prices
error is also under money supply influence. These two variables influence with each
other. On contrary, prices error is always under money supply influence. This is
consistent with the traditional economic views. And prices are influenced by another
variables time by time.

4.3 Granger Causality

To introduce a conception of Granger causality, the simplest VAR model is considered

as following:

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 (EQ4.14) xt=α0＋α1xt-1＋α2yt-1
(EQ4.15) yt=β0＋β1xt-1＋β2yt-1
(EQ4.16) xt=α0＋α1xt-1
(EQ4.17) yt=β0＋β2yt-1

Granger (1969) devises some tests for causality analysis. According to this, when β1
is zero, xt fails to cause yt. For testing this Granger causality, we have to estimates two
sets of VAR models. First, we have to estimate unconstraint (EQ4.14) and (EQ4.15)
and obtain sums of squared residual, SSR01 and SSR02, respectively. Second, we
estimate (EQ4.16), which is a constrained form that the parameter of yt-1 is assumed as
zero (α2 = 0) and obtain sum of squared residual, SSR11 and in an equal manner, we do
(EQ4.17), which is also a constrained form that the parameter of xt-1 is assumed as zero
(β1 = 0), and obtain sum of squared residual, SSR12. F statistics are calculated based
on following equations:

( SSR11 − SSR01 ) / p
(EQ4.18) 12 Fx _ y = ～F ( p, T − np − 1)
SSR01 /(T − np − 1)
( SSR12 − SSR02 ) / p
(EQ4.19) Fy _ x = ～F ( p, T − np − 1)
SSR02 /(T − np − 1)
where: p lag length of a VAR model
n variable number of a VAR model
T number of observations
SSR01 sum of squared residual of (EQ4.14)
SSR02 sum of squared residual of (EQ4.15)
SSR11 sum of squared residual of (EQ4.16)
SSR12 sum of squared residual of (EQ4.17)

There are also some critical views on Granger causality. Some economists, including
Leamer (1985), suggest to utilize the simple word “precede” instead of the complicated
word “Granger causality” since all that can be tested is whether a certain variable
precedes another, and that the time series causality, which is usually understood in the
economic fields, is not tested. However, since it has already been well established in
the econometric literature, we can adopt the concept of Granger causality with a deep
attention.

12
Here, since the VAR model discussed in this paper includes a constant term, freedom of degree of F statistics are
subject to F(p, T-np-1). When a VAR model excluded a constant term, it should be F(p, T-np).

36
Table 6: Results of Granger Causality Analysis
Unit: Probability
Estimation Period: Sep. 1990 – Jun. 1993
From Exchange Rate Money Supply Interest Rate Prices
To
Exchange Rate N.A. 0.74203 0.07230 0.34857
Money Supply 0.28220 N.A. 0.04503 0.09151
Interest Rate 0.68492 0.50230 N.A. 0.46370
Prices 0.04969 0.47700 0.14770 N.A.
Estimation Period: Jul. 1994 – Apr. 1997
From Exchange Rate Money Supply Interest Rate Prices
To
Exchange Rate N.A. 0.40843 0.03358 0.87284
Money Supply 0.14805 N.A. 0.09305 0.53811
Interest Rate 0.23768 0.46541 N.A. 0.00565
Prices 0.09450 0.12105 0.12755 N.A.
Estimation Period: May 1998 – Feb. 2001
from Exchange Rate Money Supply Interest Rate Prices
To
Exchange Rate N.A. 0.13540 0.03958 0.22760
Money Supply 0.17040 N.A. 0.94629 0.20455
Interest Rate 0.03556 0.01619 N.A. 0.41100
Prices 0.80872 0.25285 0.04416 N.A.
Source: Author’s Estimation

Table 6 reports the results of Granger causality analysis employing the VAR model.

Table 5 reveals some very interesting features. At the estimation period of September
1990 to June 1993, interest rate appears to precede other tree variables. But exchange
rate precedes prices with more probability than exchange rate does. Money supply thus
is managed in an accommodated manner. Interest rate appears the first-hand
operational object of economic policy authorities at this period. At the estimation
period from July 1994 to April 1997, we can observe almost the same causality
relationship as the previous period but prices precedes interest rate with more statistical
significance. This may be result that interest rate operation by economic policy
authorities falls behind a gradual inflation. In general, the causality analysis of these
first two periods seems quite similar. On contrary, after the Asian monetary crisis,
money supply precedes interest rate although managed in an accommodated manner at
the first two periods. Economic policy authorities might have switched the first-hand
operational object from interest rate to money supply. And interest rate precedes both
exchange rate and prices. Exchange rate also precedes interest rate. This causality

37
relationship between exchange rate and interest rate is rather difficult to be understood.

38
5. Conclusion

For concluding remarks, I mainly pick up some points of monetary and economic
policy authorities’ behavior from causality analysis, those of explanatory powers from
analysis of forecast error variance decomposition, and those of impact diffusion from
analysis of impulse response functions.

As is stressed before, since the variables employed here, except for prices, are
observed at very strongly restricted markets, the relationship among them might not be
results of markets but of economic policy authorities’ behavior and/or response, such
as the government and/or the central bank.

5.1 Implications to Economic Policies

Relating to monetary and economic policy authorities’ behavior, the first two periods,
such as that from September 1990 to June 1993 and that from July 1994 to April 1997,
are quite similar. Interest rate appears the main first-hand operational object variable of
authorities. The operation of interest rate then influences other variables. Among them,
money supply is subject to an accommodated manner. On contrary, after the crisis,
shocks on exchange rate have a sizable impact on another variables, especially money
supply and interest rate. This might be consistent with some phenomena observed in
Indonesia. At present, exchange rate is one of the most important factors.

But after the monetary crisis, the analysis of Granger causality reveals that money
supply gets the position of the first-hand operational object to another variables to
sizable extent. It might have some relations with the liberalization of money and
financial markets because this is a normal diffusion route in developed countries. Both
exchange rate and interest rate are operated by money supply and diffuse prices,
containing a strong repercussion with each other. But since the data employed here
fluctuate so much in this period, it is very difficult to find out clear direction of
diffusion. On the other hand, since forecast errors of interest rate and prices are
explained by exchange rate to a large extent, authorities’ switched operations based on
money supply after the monetary crisis are not so successful. This may be a natural
outcome of economic turmoil in Indonesia but authorities behavior changed to a rather
normal direction compared with other developed countries, which should be continued.

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5.2 Implications to Economic Modeling

Apparently, the results of analysis supports that before the crisis, money supply should
be formulated as a function of interest rate and after the crisis, contrarily, interest rate
should be formulated as a function of money supply in a model while, off course, there
seems that a strong repercussion exists. And it could be stated that before and after the
crisis, the lag pattern is totally changes. According to the analysis of impulse response
function, money supply, which is the first-hand operational object variable of
authorities’ policy very quickly diffuse other variables, such as exchange rate, interest
rate, and prices, since shocks to money supply are quickly absorbed by itself.

For the purpose of forecasting economy employing a model, after the monetary crisis,
a sizable extent of errors in money supply, interest rate, and prices is originated from
fluctuations of exchange rate, compared with preceding periods, so that at present it is
recommended to treat exchange rate as exogenous. And alternative simulations based
on various exchange rate assumptions must be examined. Also prices are now
fluctuating as if residuals of other variables almost equal to money supply at the
preceding two periods before the crisis, which is resulted from analysis of forecast
error variance decomposition, so that we must pay a deep attention when estimating
prices equations.

40
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