Determination of Equilibrium Exchange Rate Rupiah Against US Dollar and its Volatility: Application of Asset Approach

Abstract

The prevailing exchange rate and its volatility has been always an important issue in an open economy and freely floating exchange rate system, such as in Indonesia. In this system, the exchange rate is allowed to fluctuate based on the interaction between demand for and supply of foreign currency in the foreign exchange market. Its fluctuation may influence many economic activities and can be transmitted to the inflation rate. This shows that the prevailing exchange rate and its volatility become a crucial variable that must be taken into account by all economic actors. This paper aims to describe the application of asset approach in determining the equilibrium exchange rate Rupiah against US$ and analyze the factors that influence its volatility. The analysis method used is the applied method based on the theory of Uncovered Interest Parity (UIP) condition. The result shows that the actual exchange rate is completely different from the equilibrium exchange rate where Rupiah is undervalued towards US$. It reflects that the demand for US$ is greater than its supply which means that foreign exchange market is not in equilibrium. When all else equal, a decreasing of Rupiah interest rate, an increasing of US$ interest rate and a rising of expected future exchange rate, respectively, will depreciate Rupiah against US$. The changing of these three factors can show and describe clearly its effect on the volatility of exchange rate.