ANALYSIS OF EXCHANGE RATE DECOMPOSITION IN INDONESIA: A VECM APPROACH

Abstract

Increased economic openness has brought significant changes to the dynamics of global trade. This study uses the Vector Error Correction Model (VECM) method to analyse the exchange rate relationship with GDP, remittances, investment, and inflation in Indonesia for the period 2011Q1-2023Q4. The study aims to separate the short-run and long-run effects and uses variance decomposition to identify the contribution of each variable to the exchange rate. The analysis shows that investment has a significant effect on the exchange rate in the long run, while GDP, remittances, and inflation have no significant impact. In the short run, investment shows a negative impact on the exchange rate, reflecting its sensitivity to market dynamics. Moreover, variance decomposition reveals that the exchange rate variable itself becomes the dominant factor in exchange rate movements, followed by investment. This study supports the Purchasing Power Parity (PPP) theory by highlighting the importance of investment in maintaining exchange rate stability. The results are expected to serve as a reference for policy makers in designing effective exchange rate management strategies.