Summary of Findings and Policy Implications

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