Two Stage Markov Switching Model: Identifying the Indonesian Rupiah Per US Dollar Turning Points Post 1997 Financial Crisis

This paper aims to identify the Indonesia rupiah per US dollar turning points using a regime switching model. Firstly, to detect if nonlinear model suits the data at hand, the BDS test and CUSUM of square test was used and the results indicates that a nonlinear model suits the data. The paper then proceeds by using a univariate two state Markov Switching autoregressive model (MSAR) developed by Hamilton (1989), Engel and Hamilton (1990) to capture regime shifts behaviour in both the mean and the variance of the Indonesian rupiah per US dollar exchange rate between 2000 to 2015. The empirical evidence indicates strong transition probabilities suggesting that only extreme events can switch the series from an appreciation regime to a depreciation regime vice versa. Moreover, the results of the MSAR model was found to successfully capture the timing of the regime shifts of the Indonesian rupiah per US dollar exchange rate because of government intervention, Indonesian presidential elections, US financial crises of 2008, and the Indonesian current account deficit in 2013. Finally, the non-linear exchange rate dynamic of the Indonesian rupiah implied that regime-switching models have potential important implication for the macroeconomic literature documenting the effect of monetary policy shock and political environment on the economic aggregates. Furthermore, regime-switching models is well suited to capture the non-linearities in exchanges rate.