Stabilising the Rupiah Exchange Rate

In the article “Dollar Exchange Rate Mismatch”, the distinction between ‘voice’ and ‘noise’ factors in dollar exchange rate volatility was explained. The ‘voice’ factor reflects economic fundamentals, whereas the ‘noise’ factor represents market anxiety. The current weakening of the Rupiah does not reflect economic fundamentals due to the significant influence of the noise factor.

Firstly, as market anxiety increases, more noise traders become involved in transactions. Researchers Jeanne and Rose from the National Bureau of Economic Research (NBER), in their study “Noise Trading and Exchange Rate Regimes”, explain that the presence of noise traders can create multiple equilibria within the foreign exchange market.

The entry of noise traders increases exchange rate volatility risks while simultaneously distributing those risks. Secondly, the high volume of noise traders causes a disconnect between economic fundamentals and the Rupiah exchange rate.

Devereux and Engel, researchers at the NBER, in their study “Exchange Rate Pass-Through, Exchange Rate Volatility, and Exchange Rate Disconnect”, explain the factors causing exchange rate movements to fail to reflect a country’s economic fundamentals. These include: first, incomplete international financial markets; second, international price structures and product distribution that nullify or minimise the wealth effect of exchange rate movements; and third, the existence of stochastic deviations from uncovered interest rate parity (UIP). A minimal wealth effect is evidenced by the low return of export foreign exchange earnings to Indonesia.