Summary of the Main Findings

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6.1 Summary of the Main Findings

Our main findings suggest that the domestic economy tends to be forward-looking when anticipating future economic growth, in accordance with the main postulates of the rational expectations school of thought in macroeconomics. However, the economy tends to be rather backward-looking in terms of formation of expectations on inflation, suggesting high inertia in the public’s perception of inflationary pressures. The exchange rate plays a very central role in the goods and services market the IS equation as well as in determining the rate of inflation. The role of external demand is quite important in boosting the output level of Indonesian economy as evident in our estimation results and in one of our scenario exercises. The money supply is found to have some impact on inflation. In our final exercise, we also found that the inclusion of an exchange rate term in the policy rule helps in terms of reducing output and inflation variability. With some reference to the exchange rate, we want to highlight some empirical findings. Svensson 2000 outlines several channels through which monetary policy in the context of an open economy affects the economy. Firstly, a change in the real exchange rate implies a change in relative prices between domestic and foreign goods that will reinforce the aggregate demand channel of the transmission mechanism. Secondly, a change in the exchange rate will alter the domestic currency price of imported goods and hence contribute directly to consumer price inflation. These effects are apparent in the Indonesian economy, as our SSMM has shown. Given the high import content in the domestic production sphere, the role of the exchange rate pass through is crucial in determining the inflation rate in the economy. It is also worth noting that the 173 transmission lag of the exchange rate channel is relatively short and hence monetary policy reaction should be tailored accordingly to avoid any inflationary bias. For the reasons we have mentioned, there is a growing consensus that an explicit modeling of the exchange rate is a necessary condition for a macroeconomic model to provide a credible description of the monetary transmission mechanism in a small open economy. This is also evident from the rapid increase in the number of structural models with an explicit role for the exchange rate such as Dornbusch 1976, Blake and Westaway 1996, Ball 1999, Svensson 2000, Batini and Nelson 2000, Leitemo and Røisland 2000, and Leitemo and Söderström 2000. Our study shows that the exchange rate plays a crucial role in the conduct of monetary policy and in ensuring the stability of the Indonesian economy. Our results regarding the exchange rate is in line with key findings from Siregar and Ward 2002, who built a structural vector auto-regression SVAR model for Indonesia. In their study of the monetary transmission mechanism, they found that monetary policy shocks affect domestic output through the effect of the short-run interest rate on the real exchange rate using the impulse response analysis. This result validates our finding that the interest rate does not affect non-oil output directly but instead through the exchange rate channel. Based on dynamic simulations of our model, we have investigated the effects of an increase in external demand on the economy. As we have mentioned earlier, the economy will benefit from this increase in the external demand since it functions as additional economic fuel to enhance the economic growth of the Indonesian economy. In 174 the simulation exercises, we have also found that the Central Bank needs to have a certain level of credibility to achieve the inflation target. Regarding the inflation transmission mechanisms, we experiment with two types of inflation measure: core and headline inflation. We found that by reacting to core inflation, BI will be able to manage the fluctuations in output much better as compared to when BI is responsive to headline inflation. In our stochastic simulation exercises, we experimented with two alternative policy rules in the Indonesian SSMM. Our results, interestingly, show that both types of rules Taylor and McCallum perform equally well. However, we feel that for a developing country like Indonesia, a policy rule that can reduce output volatility at the expense of a slight increase in inflation variability is more appropriate. The policy frontiers traced out from the Taylor rule by varying the relative weights in the output and inflation gaps show that by giving attention to both output and inflation, the variability in these two very important macroeconomic variables can be reduced. Furthermore, our dynamic simulations show that a Taylor rule augmented with the nominal exchange rate would outperform the simple Taylor rule in reducing the volatility of both output and inflation, although the improvement is relatively minor.

6.2 Policy Implications