Long-run dynamics and error correction mechanism of inflation in Indonesia: a vector error correction model approach

Abstract

This study examines the impact of BI Rate fluctuations and exchange rate movements on inflation stability in Indonesia from August 2016 to August 2025. The Vector Error Correction Model (VECM) maps long-term, short-term, and dynamic responses among variables. VECM estimations reveal a significant long-term equilibrium with an Exchange Rate coefficient of 1.9314 and a BI Rate coefficient of -0.0917. These findings highlight a high exchange rate pass-through, in which price stability is more sensitive to currency fluctuations than to interest rate policy. Variance Decomposition analysis confirms substantial inflation inertia, dominated by a self-shock of 97.16%. Meanwhile, the insignificant Error Correction Term (ECT) of -0.0554 suggests a slow adjustment mechanism toward equilibrium. Consequently, monetary authorities are advised to prioritize exchange rate stability and public expectation management to mitigate structural price pressures.