The Determinants of Inflation in the Indonesian SSMM

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4.3 The Determinants of Inflation in the Indonesian SSMM

We have introduced Equation 13 to model the inflationary process in the Indonesian economy. In this section, we provide a more detailed discussion of the determinants of inflation and the potential channels of monetary policy transmission. 4 The aggregate demand AD channel In general, monetary policy works mainly through its influence on aggregate demand of the economy. In our Indonesian SSMM, the AD channel reflects the traditional interest rate mechanism whereby the policy instrument assuming it is a nominal interest rate affects the real interest rate and thus the current output gap. This relationship is captured by the 1 + − t t t E i π variable that represents the real interest rate. Subsequently, changes in the output gap will affect the inflation rate. Typically, changes in interest rate as a policy instrument will achieve its maximum impact on inflation after a 2-years lag see for example Bank of England 1999, pg. 3. The exchange rate channel In our SSMM, changes in the nominal interest rate affect inflation indirectly through the exchange rate. This indirect effect comes about through the UIP relationship given in Equation 12. For example, higher domestic nominal interest rates will attract capital inflows which tend to appreciate the nominal exchange rate. Subsequently, imported products and raw materials will be cheaper domestically, thus putting downward 4 The explanation of the transmission mechanism of monetary policy is by no means exhaustive. Readers are referred to Bank of England 1999 for further details. 109 pressures on inflation. This represents the pass-through effect of the exchange rate on the inflation rate in Indonesia. The exchange rate also affects inflation through the aggregate demand channel. From the identity f t t t t p p e q − + = , it is seen that the nominal exchange rate partly determines the real exchange rate, which in turn affects the IS equation. Specifically, a real appreciation lowers Indonesia’s export competitiveness and consequently real GDP, thus acting to mitigate domestic inflationary pressures. The expectations channel The Indonesian SSMM incorporates the expectations of rational agents via the forward- looking terms in Equations 8, 12, and 13. The current output gap is determined by the expected output gap and expected inflation rate as specified earlier. The current nominal exchange rate is determined partly by the expected future nominal exchange rate. Expected future inflation is also crucial in determining the current level of inflation. All these expectations, which depend partly on anticipated changes in monetary policy, have effects on the current inflation rate either directly or indirectly. The money supply channel The last factor that could determine the current level of inflation is changes in the money supply. In accordance with the quantity theory of money, changes in the money supply will eventually determine the nominal values of goods and services in the long run. Hence, it follows that both the general price level and inflation are potentially determined 110 AD Output Gap Nominal Exchange Rate UIP AD INFLATION by decisions on the money supply. If this is the case, inflation is partially a monetary phenomenon. Validating or disproving this monetary hypothesis for the Indonesian economy is another of our concerns in this thesis. However, the process of determining the money supply itself might be important in understanding the monetary transmission mechanism. We discuss this in greater detail in Section 4.5 on policy rules in the Indonesia SSMM. The determinants of inflation in the Indonesia SSMM can be summarized by the following flowchart: Figure 4.1 Flowchart of the Determinants of Inflation in Indonesian SSMM Expectations Interest rates Money Supply Note: Ovals denote originating variables that determine inflation, rectangles denote intermediate variables that determine inflation, and bold letters denote the equations that appear in the Indonesian SSMM. Solid arrows denote direct transmission onto inflation while broken arrows denote indirect transmission onto inflation. 111

4.4 Policy Rules for the Indonesian SSMM