Does Trade Openness and Inflation Rate Have Dynamic Interconnected Patterns? An Autoregressive Distributed Lag (ARDL) Model Co-integration Approach

Abstract

The relationship between trade openness and the inflation rate is a contentious issue that has received considerable attention from economic policymakers. This study aims to examine the relationship between trade openness and the inflation rate in Indonesia. To achieve this objective, the study utilizes an autoregressive distributed lag model (ARDL) co-integration approach to analyze annual data covering the period from 1985 to 2022. The results of the bound test confirm the existence of a long-run relationship among the variables. Empirical findings reveal that trade openness is positively associated with inflation in the long run. Conversely, real gross domestic product (GDP) and foreign direct investment (FDI) exert negative influences on the inflation rate in the long run. This indicates that GDP and FDI are significant variables in reducing the inflation rate. Moreover, the results of the error correction model (ECM) are statistically significant with an expected negative sign. This suggests that disequilibrium occurring in the model can be corrected in less than two years at a rate of 51% per annum. These findings underscore the critical need for Indonesia to improve initial conditions for trade openness. This can be achieved through supporting and encouraging the export sector, diversifying exports into international markets, reducing reliance on raw material exports, and developing economic infrastructure.