The Portofolio Model of Exchange Rate Determination: The case of Rupiah exchange rate Agus Budi Santosa, Agung Nusantara, Sri Nawatmi Department of Management Universitas Stikubank Semarang, Indonesia agusbudi@edu.unisbank.ac.id Abstract—Indonesia economy is prone to the world economy that makes Rupiah sensitive and volatile. Thus, it affects macroeconomic stability. In conclusion, Rupiah exchange rate should be maintained in order to maintain macroeconomic stability. An approach model development of Rupiah exchange rate is needed to explain the behavior of Rupiah exchange rate to US dollar. This research aimed to analyze Rupiah exchange rate behavior based on portfolio model. This research can be used to determine exchange rate management policy to stabilize rupiah. The Portfolio exchange rate model explained that the exchange rate nominal was influenced by cumulative current account change and exchange rate value was determined by stock equilibrium. Analysis method used error correction model (ECM) to test the portfolio model. If in the short term there is an imbalance, the ECM model will correct it in the long run. With this mechanism the problem of smooth regression can be avoided through the use of difference variables that remain in the model without losing long-term information caused by the use of different data only. The research period was 2000.1-2016.4 by using quarterly period. The research result find that variables in portfolio model showed national income, interest rate, and foreign exchange reserves influenced Rupiah exchange rate to US dollar in short run. In the other hand, price variable did not significantly influence Rupiah exchange rate to US dollar. Based on the test of portfolio model, a Rupiah exchange rate stabilization policy could be assigned based on foreign exchange reserves management. Keywords—exchange rate; macro economic stabilility; portofolio; error corection model; foreign exchange reserve I. INTRODUCTION This research is important as Rupiah exchange rate fluctuation will influence macroeconomic indicators. A good exchange rate management will keep Rupiah exchange rate stabilization. Portfolio balance model sees from other aspects towards exchange rate fluctuation. According to this model, exchange rate is influenced by micro factor such as participants of foreign exchange rate market that reflected on asset management by considering risk factor. Portfolio balance approach stated that domestic currency is just one kind of financial assets demanded by a country’s citizens. In a simple portfolio balance approach, all individual and companies have financial wealth in various assets combinations in form of domestic currency, domestic obligation, foreign exchange reserves etc. [1]. This approach stated that the amount of exchange rate is determined by cumulative change of current account, while foreign currency agents conducted portfolio that agreeing upon exchange rate risk. The foreign currency agents also believe that the risk couldn’t be eliminated by conducting diversification. Thus, they perceive that equilibrium at stock market determined exchange rate. The existence of risk implies that interest rate difference is equal to change expectation on exchange rate plus premium risk [2]. Portfolio equilibrium in short term explains some stock allotment of wealth between security fraud alternatives and expected result and exchange rate. The equilibrium portfolio shock is assumed to be eliminated by immediate adjustment of exchange rate and interest rate [3]. Thus, the wealth owner creates demand exactly the same with financial supply and demand in short term. As long as the assumed price was constant, the exchange rate changes will influence payment balance. As a result, flexible exchange rate brings about changes in net foreign claims and wealth. Current account change is also important in portfolio balance model in arrangement redistribution of international wealth. The digression of portfolio equilibrium is also important to that the capital interaction and other economic variable will be able to explain exchange rate movement. In portfolio balance model, money demand depends on the domestic interest rate and national income. Foreign variable, such as foreign interest rate, price level, and foreign national income are assumed as exogenous variables. Next, domestic and foreign security frauds were viewed as equal in term of period and risk. There is no capital flow supervision and no transaction fee, but market imperfection exists [4,5]. The changes of exchange rate, interest rate, wealth, and future assets value prediction will change financial markets equilibrium and push every investors to relocate their financial assets in order to meet the new equilibrium or portfolio balance for both long and short terms. The striking difference in size and speed adjustment between financial stock and real factor 2nd International Conference on Banking, Accounting, Management and Economics (ICOBAME 2018) Copyright © 2019, the Authors. Published by Atlantis Press. This is an open access article under the CC BY-NC license (http://creativecommons.org/licenses/by-nc/4.0/). Advances in Economics, Business and Management Research, volume 86 140