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European Journal of Economics, Finance And Administrative Sciences - Issue 18 (2010)

price stability in the economy. Conceptually, the inflation can be divided into two sides, namely: demand side inflation (demand pull inflation) and supply side inflation (cost push inflation).

For open-economy countries, inflation comes from domestic factors (internal pressure) and also overseas factors (external pressure). The sources of external factors are the increase in the world commodity prices or exchange rate fluctuation. The influence of exchange rate towards inflation itself depends on the choice of exchange rate regime in the country.

Exchange rate system has an important role in reducing or minimizing the risk of fluctuations in exchange rates, which will have an impact on the economy. Any changes in exchange rates will have a great impact on the economy. As an example, when the Thailand government's decide to float the Thai Baht in mid-1997, it caused the financial crisis that pervade (contagion effect) in ASEAN, which is also known as the Asian financial crisis. The crisis is causing the exchange rate of domestic ASEAN countries and even some East Asian countries sharply depressed.

In the system of floating exchange rates, exchange rate fluctuations can have a strong impact on the level of prices through the aggregate demand (AD) and aggregate supply (AS). On the aggregate supply, depreciation (devaluation) of domestic currency can affect the price level directly through imported goods that domestic consumers pay. However, this condition occurs if the country is the recipient countries of international prices (international price taker). Non direct influence from the depreciation (devaluation) of currency against the price level of a country can be seen from the price of capital goods (intermediate goods) imported by the manufacturer as an input. The weakening of exchange rate will cause the price of inputs more expensive, thus contributing to a higher cost of production. Manufacturers will certainly increase the cost to the price of goods that will be paid by consumers. As a result, the price level aggregate in the country increases or if it continues it will cause inflation.

Studies concerning the relation between inflation and exchange rates have been done for several decades. Using the Granger Non-Causality Test based on Kenyan Data during the period of 1970-1993, Ndungu’ (1997) showed that the level of domestic inflation and exchange rate changes affect each other. Ndungu's conclusions are as follows:

  • 1.

    The level of inflation and changes in exchange rates affect each other,

  • 2.

    Domestic credit affects the level of inflation without the return effect of inflation back to

domestic credit,

  • 3.

    The level of domestic inflation and reserve changes affect each other,

  • 4.

    Changes in exchange rates and reserve changes affect each other,

  • 5.

    Changes in domestic credit and international reserves affect each other.

Rana (1983) showed that the changes in exchange rates do not affect the inflation rate in ASEAN, except Thailand. On the otheer hand, Kamin and Klau (2003) empirically found the relationships between inflation and the real exchange rates in most countries of Asia and Latin America. Furthermore, they found that the effect of exchange rates changes on inflation in Latin America was significantly higher than those in Asia and industrialized countries.

The previous studies so far show an inconclusive results. Therefore further research in this topic is needed. This paper is devoted to explore the relation between inflation and exchange rates in ASEAN+3 countries. Together with the European Union (EU) and North America, those three areas is currently the regional center of the world economy. In this paper we will compare the results of the study in Asian countries with those of the EU and North American regions. Comparing with previous studies, this research will include more regions (countries) using the new data. Moreover, this paper will also include two dummy variables in the analysis, they are area dummy (Asia and Non-Asia) and the crisis dummy (before and after the Asian Crisis).

The rest of the paper will be organized as follows: In section 2 literature review related to the problem will be summarized. Section 3 will then explain the data and research methodology, followed by a discussion on section 4. Summary of the results and the policy implications will be provided in section 5.

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