iv 5.2
Estimation Methods
119 5.2.1 Single
Equation versus
System Methods
119 5.2.2 Estimation
Methods for
Indonesian SSMM
122 5.3
SSMM Estimates
124 5.4
Simulation Methods
and Results
132 5.4.1 Deterministic
versus Stochastic
Simulations 133
5.4.2 Model-Consistent Expectations
134 5.4.3 Solution
Algorithms 137
5.4.4 Baseline Simulation
Results 139
5.5 Scenario
Analysis 144
5.5.1 A Positive Shock in Foreign Income 144
5.5.2 The Role of Credibility in Inflation Targeting 149
5.5.3 Headline or Core Inflation: Which Measure Should Be Used? 152
5.6 Alternative
Monetary Policy
Rules 158
5.6.1 The Settings of Stochastic Simulations 158
5.6.2 A Quest for Best Monetary Policy Response 159
5.6.3 The Policy
Frontier 164
Chapter 6: Summary of Findings and Policy Implications
171
6.1 Summary of the Main Findings 172
6.2 Policy Implications 174
6.3 Limitations and Further Research 181
v
Bibliography 184 Appendix
1 196
Data Appendix
197
vi
Summary
This thesis aims to capture the fundamental structure of the Indonesian economy through the construction and simulation of a small scale macroeconomic model SSMM. An
SSMM is an aggregated model with considerable theoretical content that contains far fewer equations than large-scale macroeconomic models and provides direct analytical
solutions. Recently, SSMM has been adopted by countries that target inflation directly, such as New Zealand, Canada, Brazil, the United Kingdom, Sweden, Finland, Australia,
and Spain. Thus it is rather timely to devise an SSMM for Indonesia as it is currently moving towards an inflation targeting regime amidst the structural changes that had taken
place since the Asian financial crisis. Chapter 1 will state the motivation behind our thesis and it will be followed by an outline
of the thesis. We discuss recent developments in the Indonesian economy, most notably before and after the financial crisis that struck Indonesia in 1997 before we move on with
the construction of Indonesian SSMM in Chapter 2. This chapter contains an exposition of the macroeconomic developments in Indonesia with special attention devoted to
certain economic variables that play key roles in promoting macroeconomic stability. This chapter is meant to be a narrative analysis of stylized facts. Moreover, this chapter is
a building block for modelling the Indonesian economy using an SSMM and provides a background for the simulations in the later part of the thesis. Chapter 3 deals with the
review of theoretical foundations for small scale macroeconomic models. Specifically, we will take a closer look at three different small scale models, namely: The Batini-
Haldane model for the United Kingdom, the Reserve Bank of Australia model, and Brazilian model. In addition, we will also discuss several types of policy rules that are
commonly used to close an SSMM. We build the Indonesian SSMM in Chapter 4 with the specific objectives of discussing
the empirical findings from the model; to understand the important macroeconomic factors affecting the Indonesian economy; and to identify key policy vehicles that can
play central roles in sustaining non-inflationary economic growth in Indonesia. In this chapter, we will also have a detailed discussion about the determinants of the inflation
rate in the Indonesian economy. Finally, we end Chapter 4 by reviewing the recent trend of monetary policy conduct in Indonesia before we specify the policy rules for the
Indonesian SSMM. Chapter 5 deals with the estimation and simulation results from the Indonesian SSMM that we have built earlier. We carry out several dynamic simulations
of the economy to investigate the effects of external shocks such as an increase in external demand; to understand the role of central bank credibility; and to experiment
with different policy rules, such as interest rate rule and money supply rule, in the Indonesian SSMM. In line with the ultimate goal to achieve a non-inflationary economic
growth for the Indonesian economy, we also put some emphasis in understanding two different measures of inflation core and headline through the simulation exercises. In
particular, we trace out the policy frontier for the Taylor rule in the Indonesian economy and discuss the issue of appropriate policy response. Finally, Chapter 6 summarizes the
main empirical findings and discusses some policy implications based on this study. All in all, we desire to understand viable policy options to support the objective of achieving
sustained and continuous economic growth for Indonesia.
vii
List of Tables
Table 2.1 Selected Key Macroeconomic Indicators of Indonesia, 1963-1980
16 Table 2.2
Selected Key Macroeconomic Indicators of Indonesia, 1981-1986 19
Table 2.3 Selected Key Macroeconomic Indicators of Indonesia, 1987-1996
21 Table 2.4
International Claims Held by Indonesian Banks–Distribution by Sectors and Maturity in Billions of US Dollars
25
Table 2.5 Indonesias Gross Domestic Product Share by Industrial Origin
27 Table 2.6
Current Accounts of Four Southeast Asian Countries of GDP 28
Table 2.7 Government Fiscal Balances of Four Southeast Asian Countries
of GDP 28
Table 2.8 Share of Indonesian Exports to Selected Countries, 1991-1997
29 Table 2.9
International Claims Held by Indonesian and Thailand Banks-Distribution by Country of Origin Billions of US Dollars
30
Table 2.10 Key Macroeconomic Variables of the Indonesian Economy:
Crisis and Post-Crisis Periods, 1997-2001 36
Table 5.1 Estimation Results of the IS Equation
124 Table 5.2
Estimation Results of the Oil Equation 125
Table 5.3 Estimation Results of the LM Equation
125 Table 5.4
Estimation Results of the Inflation Equation 126
Table 5.5 Estimation Results of the Taylor Rule
126 Table 5.6
Components of CPI and Volatilities 153
Table 5.7 Output Gap and Inflation Volatilities
163 Table DA.1
Variable Description 200
Table DA.2 Augmented Dickey-Fuller Unit-Root Tests
200 Table DA.3
Descriptive Statistics for Variables 203
viii
List of Figures
Figure 4.1 Flowchart of the Determinants of Inflation in Indonesian SSMM
110 Figure 4.2
Relationship between Nominal Interest Rate and Money Supply 113
Figure 5.1 Relationships between Money Supply, Inflation and the Interest Rate
130 Figure 5.2
Baseline Simulation Results Endogenous Variable: Total Output 140
Figure 5.3 Baseline Simulation Results Endogenous Variable: Non Oil Output
141 Figure 5.4
Baseline Simulation Results Endogenous Variable: Oil Output 141
Figure 5.5 Baseline Simulation Results Endogenous Variable: Inflation
142 Figure 5.6
Baseline Simulation Results Endogenous Variable: Money Supply 142
Figure 5.7 Baseline Simulation Results Endogenous Variable: Exchange Rate
143 Figure 5.8
Baseline Simulation Results Endogenous Variable: Domestic Interest Rate 143
Figure 5.9 Effect from a 10 Increase in Foreign Income on Total Output
145 Figure 5.10
Effect from a 10 Increase in Foreign Income on Money Supply 146
Figure 5.11 Effect from a 10 Increase in Foreign Income on Interest Rate
146 Figure 5.12
Effect from a 10 Increase in Foreign Income on Exchange Rate 147
Figure 5.13 Effect from a 10 Increase in Foreign Income on Inflation
147 Figure 5.14
Effects of Central Bank Credibility in Achieving Inflation Target 150
Figure 5.15 Headline and Core CPI and Inflation
153
ix Figure 5.16
Effect from a 10 Temporary Increase in Domestic Price on Interest Rate 157
Figure 5.17 Effect from a 10 Temporary Increase in Domestic Price on Output Gap
157 Figure 5.18
Comparison of Monetary Policy Rules 162
Figure 5.19 Policy Frontiers for the Taylor Rule Without Exchange Rate
166 Figure 5.20
Policy Frontiers for the Taylor Rule With Exchange Rate 166
Figure DA.1 Interpolation of Oil Output
199 Figure DA.2
Graphs of Macroeconomic Variables in the Indonesian SSMM 201
Figure DA.3 Graphs of Macroeconomic Variables in the Indonesian SSMM Continued
202
1
Chapter 1 Introduction