Causality relationship among interest rate, inflation, exchange rate using vector autoregression

Abstract

This paper aimed to analyze the causal relationship between interest rates, inflation, and exchange rates in Indonesia. This paper used Vector Autoregression (VAR). The Granger causality showed that the interest rate did not affect inflation, but inflation affected the interest rates. The exchange rate affected inflation, but inflation did not affect the exchange rate. As for the interest rate and the exchange rate, they did not affect each other. The Impulse Response Function of the interest rate was due to the shock of a positive change in one of its standard deviations. Inflation response to the change in one standard deviation of the interest rate initially was null in period one, increased in period two, and gradually decreased until period ten. The inflation response was due to the shock of a positive change in one of its standard deviations. In Variance Decomposition, interest rate shifting in period one and period two were still very dominantly influenced by the interest rate itself. Next, it was affected by inflation. Furthermore, changes in inflation in period one and period two were influenced dominantly by inflation itself. In the next period, interest rates and exchange rates affected inflation in a small percentage.

Keywords

• interest rate
• inflation
• exchange rate
• vector autoregression