The Bank Indonesia Small Quarterly Macromodel BI-SQM

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4.1 The Bank Indonesia Small Quarterly Macromodel BI-SQM

Before we develop the Indonesian SSMM, we will discuss in some detail the recent small macroeconomic model built by Bank Indonesia, called the small quarterly macromodel BI-SQM. BI-SQM was set up initially to forecast inflation in a more accurate way and consistently. The model is a simultaneous quarterly model that consists of the following equations: output gap, aggregate demand, real money balances, the Phillips curve, import price, and exchange rate. Finally, BI-SQM is closed by considering a monetary policy rule in the spirit of the Taylor rule, with the control of inflation as the ultimate goal. The BI-SQM output gap equation consists of an output growth variable, short- term interest rate, and the oil price. It is represented as follows with all the α coefficients are positive: t t t t t fac seasonal o i Y Y Y 1 5 3 4 3 2 1 _ ε α α α α α + + + − Δ + = − − ∗ 1 Y is real output and Y is the potential real output level. Y Δ is an output growth variable, i t is the real short-term interest rate, o is an oil price gap, and finally seasonal_fac is a dummy variable to capture seasonal events. This equation postulates that the output gap—the difference between real output and potential output— depends on the growth of actual output, which is a proxy for aggregate demand. The output gap is also directly affected by a change in the short-term interest rate. Since changes in the oil price affect revenues from oil exports, an important component of GDP, the model postulates that the deviation between the actual oil price and the one assumed in the state budget also affects 98 the output gap positively when actual price is greater than the projected price in state budget or negatively when actual price is smaller than the projected price in the state budget. Next, the aggregate demand AD equation states that the change in output is due to the growth of government consumption 1 and the short-term interest rate, the exchange rate, the real money balances, and the oil price gap: t t t t t t t t o p m e i Y Y 2 11 10 9 8 1 7 6 ε α α α α α α + + − Δ + − − Δ + = Δ − 2 e is the real exchange rate variable defined as the domestic currency price of foreign currency, m t is the money supply, p t is the price level and hence, m t - p t is the real money balances. The negative effect of the exchange rate on Indonesia’s GDP growth is due to the high import content in the production of the domestic economy. Thus, a rupiah depreciation reduces the value-added domestic profit of domestically produced goods, which in turn reduces national income as argued in Alamsyah et al. 2000. 2 Although the addition of the real money balances variable can be justified as a proxy for the wealth effect, it is puzzling that the interest rate and the oil price appear for a second time in Equation 2, considering their presence in Equation 1. 1 In Alamsyah et al. 2000, we found these descriptions for the specification of AD equation but no government consumption variable actually appeared in the equation itself. It might have been dropped from the specification due to an insignificant or trivial effect on output growth. Nevertheless, this remains a puzzle for us. 2 This statement is rather intriguing since economic theory postulates that the exchange rate should have a positive effect because an appreciation reduces export competitiveness and hence, national income. 99 The real money balances equation is as follows: t t t t t t t i p Y p m p m 3 16 15 14 1 13 12 ε α α α α α + Δ − Δ − + − + = − − 3 The income level, inflation, and changes in interest rate are used as explanatory variables. This is a standard specification for real money demand in developing countries. Next, the Phillips curve equation is described by the trade-off between inflation and the output gap: t t t t t t wpi Y Y p p p 4 20 19 18 1 18 17 1 ε α α α α α + Δ + − + Δ − + Δ + = Δ ∗ ∗ − 4 where p Δ and ∗ Δp are the current inflation rate and the inflation target respectively. In this equation, the current inflation rate depends on the lagged inflation rate, reflecting inflation inertia, and the inflation target set by the authority. In addition, the BI-SQM specification of the Phillips curve also includes supply side pressures on inflation as captured by the output gap and the growth of the import-wholesale price index WPI, with the WPI itself influenced by fluctuations in the Rupiah and the foreign price level: t F t t t p e wpi 5 23 22 21 ε α α α + Δ + + = Δ 5 where wpi Δ represents changes in the import-wholesale price index and F p Δ is foreign inflation. Next, the exchange rate equation consists of domestic and foreign interest rate 100 differentials t id and a dummy variable to proxy for the unobserved variables that partly determine the exchange rate risk premium: t t t id dummy e 6 30 29 28 ε α α α + − + = 6 Finally, BI-SQM employs an interest rate policy rule called the inflation forecast with contemporaneous output gap rule: t t j t t t Y Y p p i i 7 27 26 1 25 24 ε α α α α + − + Δ − Δ + + = ∗ + ∗ − 7 This policy rule dictates the reaction of monetary policymakers to deviations between projected inflation and the inflation target, as well as between actual and potential output. It also allows for interest rate smoothing.

4.2 The SSMM for the Indonesian Economy