A Positive Shock in Foreign Income

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5.5 Scenario Analysis

Having obtained the baseline simulation results of the Indonesian SSMM, we will move on to perform simulations under several economic scenarios. The scenarios specified are closely related to the goal of this thesis, which is to examine ways to achieve sustainable non-inflationary economic growth and to understand some viable policy options for the Indonesian economy.

5.5.1 A Positive Shock in Foreign Income

The first scenario that we are going to construct in a DD simulation is an increase in the foreign income of Indonesia’s major trading partners. We choose a 10 increase in foreign income and plot the results in terms of deviations from the baseline scenario and how many quarters it takes for the deviations to stabilize Figures 5.9 to 5.13. As expected, the domestic output gap in Figure 5.9 increases for a year before it starts to come back down to the baseline level. The deviations of total output from the baseline level are trivial after 4 quarters. We computed the dynamic elasticity of output and found that for a 10 increase in foreign income, the output gap goes up by a maximum of 14 in the second quarter i.e. after 6 months. We calculated that after one year, the cumulative multiplier effect from a 10 increase in foreign income is a 31 increase in the domestic output gap. 9 The impact from an increase in the income of Indonesia’s major trading partners on total output originates from both the non-oil equation the IS equation and the oil equation. 9 This is equivalent to an average of a 7.5 increase for each quarter. 145 Subsequently, we found a similar effect on money demand in the economy coming from an increase in total output Figure 5.10. Money demand immediately rises following an increase in the output gap with no change in the level of domestic interest rate for the first 3 quarters. After 3 quarters, there is a significant increase in the nominal interest rate that lasts for around 7 quarters Figure 5.11. This comes from the Taylor rule whereby an increase in output gap will prompt BI to increase the interest rate 3 quarters later. Following an increase in the domestic interest rate, we find an appreciation of the nominal exchange rate through the UIP relationship and this effect lasts for 7 quarters as well Figure 5.12. Figure 5.9 Effect from a 10 Increase in Foreign Income on Total Output -4 4 8 12 16 1 2 3 4 5 6 7 8 9 10 11 12 Percentage Deviation of Total Output from Baseline Period in Quarters 146 Figure 5.10 Effect from a 10 Increase in Foreign Income on Money Supply -4 4 8 12 16 20 1 2 3 4 5 6 7 8 9 10 11 12 Percentage Deviation of Money from Baseline Period in Quarters Figure 5.11 Effect from a 10 Increase in Foreign Income on Interest Rate -.1 .0 .1 .2 .3 .4 .5 1 2 3 4 5 6 7 8 9 10 11 12 Deviation of Domestic Interest Rate from Baseline Period in Quarters 147 Figure 5.12 Effect from a 10 Increase in Foreign Income on Exchange Rate -6 -5 -4 -3 -2 -1 1 1 2 3 4 5 6 7 8 9 10 11 12 Percentage Deviation of Exchange Rate from Baseline Period in Quarters Figure 5.13 Effect from a 10 Increase in Foreign Income on Inflation -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 1 2 3 4 5 6 7 8 9 10 11 12 Deviation of Inflation from Baseline Period in Quarters 148 In Figure 5.13, the inflation rate rises immediately following an increase in output and then falls after 3 quarters. There are two effects that come into play in determining inflation viz., the effect from the money supply change, due to an increase in total output, and the exchange rate change. As can be seen from the simulation results, there are initially no effects from exchange rate appreciation on the inflation rate for the first 3 quarters so that we see a rise of 1.2 and 0.8 in the inflation rate for the first and second quarters before it falls by 1 in the third quarter. The changes in these three quarters, which are due to an increase in the money supply, cause inflation to rise by cumulative amount of 1. After that, the effect from exchange rate appreciation sets in so as to reduce the inflation rate by a total amount of 1.2 for the next 3 quarters before the price level settles back down to the baseline level after about 2 years. The simulation results under our first scenario seem to be plausible, thus validating our Indonesian SSMM. In the next two scenarios, we will study the role of central bank credibility and the choice between core and headline inflation measures under an inflation targeting regime. 149

5.5.2 The Role of Credibility in Inflation Targeting