Monetary Policy Before and During the Financial Crisis

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2.5.1 Monetary Policy Before and During the Financial Crisis

The Indonesian authority was engaged in setting up credible targets for some nominal variables such as the base money M0, broad money M2, the price level, inflation rate and the gross domestic product during the successful period of crawling peg system from the early 1980s to mid 1990s. Basically, the underlying goal of the Indonesian monetary policy during that time was to achieve non-inflationary economic growth in the medium to long term. During that time, monetary policy was centred on the use of base money as the operational instrument and it has been proven to be effective in the 1980s and early 1990s Alamsyah et al. 2001 28 . As stipulated in Act No. 13 of 1968 concerning the central bank, the de jure exchange rate regime in Indonesia was to manage, safeguard, and maintain the stability of the Rupiah. In practice, the de facto regime prior to the financial crisis is a crawling peg exchange rate system. Specifically, the nominal exchange rate was managed stringently within a narrow band that followed a steady depreciation path McLeod 1997. When the financial crisis struck the country causing massive capital outflow, BI finally gave up the crawling peg regime of the Rupiah on 14 th August 1997 and switched to a market-determined system. Right after failing to hold the quasi-fixed exchange rate system in place, the authority adopted an extremely tight monetary policy of raising interest rates and forcing state enterprises to purchase the SBI Alamsyah et al. 2001. As a lender of last resort, BI was also obliged to provide massive liquidity support to prevent bank runs and financial sector collapse. This came at a cost of loosing substantial control 28 See Boediono 1998 on the effectiveness of using base money as an operational tool after the early 1990s. 45 over base money in late 1997 to early 1998 29 . This raised a concern that BI had to stabilize the price level to strengthen the value of the Rupiah as well as to maintain macroeconomic stability. Furthermore, the financial crisis that hit Indonesia in 1997– 1998 massively drained foreign exchange reserves from Indonesia, which subsequently resulted in the collapse of the Rupiah. During the period of financial crisis, there are two main differing views and arguments regarding how BI should rectify the problems and find a way out for the ailing Indonesian economy. The first concerns the use of interest rates to stabilize the economy. In May 1998, BI placed ceilings on deposit rates and inter-bank rates for bank liabilities aimed at preventing banks from adopting imprudent and destabilizing measures. We believe that although interest rate decisions will eventually affect the movements of the money supply, it was for a different purpose that BI resorted to the use of interest rates. To prevent a relatively small proportion of people who held substantial assets in Indonesia from “running away”, BI needed to use high interest rates to prevent them from “parking” their funds elsewhere, which would further destabilize the economy. In other words, BI used interest rates to control exchange rate movements but during the crisis period Grenville 2000 argued that the highly volatile exchange rate movements were not offset by higher interest rates since they were driven by other forces. The use of the interest rate instrument was complemented by BI’s policy to set quantitative targets for base money through open market operations, with the support of 29 Alamsyah et al. 2001 pointed out that base money grew by 115 between November 1997 and July 1998. 46 the IMF. However, due to the underdeveloped market for SBI, open market operations were not that effective in absorbing excess liquidity in the economy. To tackle this issue, BI used the auction method to determine the SBI rate to help strengthen open market operations. Another innovation was the “Rupiah intervention” for more details see Alamsyah et al. 2001, pg. 313. There were also some intense debates about whether the strategy of targeting base money was feasible as opposed to using interest rates to stabilize the economy see Grenville 2000 and Fane 2000a, b. Another important point was raised by Iljas 1999 arguing that BI had targeted monetary base during the crisis period only as a temporary measure to offset the monetary expansion that resulted from providing liquidity to support the banking and financial system. It was not based, he argued, on fundamental reasons such as a stable relationship between base money and inflation. We personally feel that there are some shortcomings in using the level of base money, or base money growth, to achieve the inflation target for the Indonesian economy. Thus, it will be difficult to assess the effectiveness of base money as an instrument to control inflation during the crisis. First of all, BI was under pressure at that point in time to breach its monetary targets by Soeharto as to facilitate the provision of large subsidised loans to the Texmaco group Fane 2000b. This means that BI has not been independent in setting up its own target, be it the inflation rate target or the level of base money or base money growth. Secondly, after BI was given independence in conducting its monetary policy and goals McLeod 1999, the target level might change over time if BI seemed unable to meet the target and there are no penalties imposed on it 47 see McLeod 2003. This is because BI was not only given “instrument independence”, but it determined the inflation target in each calendar year. Thus, there is an inclination to “forgive” itself whenever BI missed the target level, causing it to have loose objectives in setting up the target. Thirdly, the causal relationship between base money and inflation is very much in doubt de Brouwer 2003. We can see from the arguments above regarding the conduct of monetary policy during the crisis period that both interest rates and base money were used in the stabilization of the economy and the inflation rate. However, we agree with Iljas 1999 that base money is used only as a temporary measure to prevent bank runs and collapse and to satisfy day-to-day demand from public. This is very much in line with the economic conditions of Indonesia whereby majority of her people needed nominal cash to meet their daily needs and transactions instead of worrying about what will happen to the value of their assets due to inflation. Thus, if BI had kept its base money in check according to IMF’s prescription—which means restricting the level of base money and reducing the ability of meeting the public’s demand for cash—the majority of the Indonesian people would have suffered more from the impact of rising inflation as history has shown in the 1960s when inflation surged to 600 per annum. Our stand is precisely that of Iljas 1999 when he argued that the expansion of base money was not because there is or was a stable and one-to-one relationship between money supply and inflation, but it was because of rising inflation that needed to be accommodated by expanding the money supply. Thus, money supply expansion has resulted from an upsurge in inflation and it was not monetary expansion that caused high inflation. We 48 therefore specify an appropriate money supply rule for the Indonesian SSMM in the next section.

2.5.2 The Recent Conduct of Monetary Policy