Forward-Looking Rules Policy Rules in SSMMs

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3.4.2 Forward-Looking Rules

An example of a forward-looking rule can be found in the BH model as follows 27 : 1 1 ∗ + ∗ − − + − + = π π ρ δ δ j t t t t t E r r r 18 r t denotes short-term ex-ante real interest rate whereby r t = i t − E t π t+1 , with i t being the nominal interest rate; r t denotes the equilibrium real interest rate; E • = E• | t Ω where t Φ denotes the information set available at time t and E is the mathematical expectations operator. The distinguishing feature of this simple forward-looking rule is that it feedbacks from the expected values of future inflation, i.e. there is a forward-looking element in inflation 28 . It resembles monetary policy behaviour in most inflation targeting central banks in reality. According to this rule, the central bank controls the nominal interest rate i t to hit a path for the desired short-term real interest rate. The feedback term implies that any deviation of expected future inflation from the inflation target prompts an immediate policy action today. In addition, this simple forward-looking rule may approximate the optimal feedback rule Batini and Haldane 1999. The policy choice variables for the authorities are the parameter triplet {j, ρ,δ}. The variable δ dictates the degree of interest rate smoothing Williams 1997 while the parameter ρ is a policy feedback parameter that determines the degree of aggressiveness of the monetary policy response to inflation. t Ω denotes the information available up to time t to the central bank. Finally, j is the targeting horizon used by the central bank for 27 Note that this rule could be augmented with explicit output terms. 28 Batini and Haldane 1999 called this the inflation-forecast-based rule. 94 simulation and calibration purposes. Usually this targeting horizon is about two years or eight quarters equivalently. Batini and Haldane 1999 calibrated this policy rule by setting δ = 0.5—a halfway point in the degree of interest rate smoothing—ρ=0.5 and j=8. They calibrated the model so as to match the quarterly profiles of the endogenous variables in the United Kingdom economy. There are several theoretical justifications for the simple forward-looking rule and some reasons why it might be preferred to the simple Taylor rule. It has been argued that expected-inflation targeting rules of the sort discussed here have desirable properties such as in the case when authorities only care about inflation; in this case, the optimal rule is the one that sets interest rates to bring expected inflation into line with the inflation target at a particular horizon. In addition to that, the central bank might also care about non- inflationary output growth; hence the optimal rule is to less than fully close any gap between expected inflation and the inflation target 29 . In other words, the simple forward- looking rule is directly analogous to the simple Taylor rule. Having explained some variants of small scale macroeconomic models along with policy rules, we will specify and estimate an SSMM that makes use of theoretical underpinnings similar to the BH model in the next two chapters. In Chapter 4, we will combine the understanding of the Indonesian economy in Chapter 2 with the theoretical foundations of small scale macroeconomic models in this chapter to construct and 29 See King 1997, Svensson 1997 a, b and Haldane 1998. 95 analyze our very own Indonesian SSMM. Chapter 5 will deal with the estimation and simulation of the Indonesian SSMM. 96

Chapter 4 A Small Scale Macroeconomic Model of the Indonesian Economy

In this chapter, we develop a small scale macroeconomic model for the Indonesian economy. To reiterate, this thesis aims to meet the challenge of improving the small model for Indonesia developed by Bank Indonesia and hopes to pave the way for future research in this area so as to gain a better understanding of the key macroeconomic structure of Indonesia and to improve on the conduct of monetary policy. In this chapter, we will synthesize our knowledge of the Indonesian economy and construct an SSMM for Indonesia, as one of the few countries in Asia for which an SSMM is built. We will begin by reviewing the existing small scale model developed recently by Bank Indonesia. This will be followed by a description of the equations in our Indonesian SSMM. In doing so, we employ a model structure that is similar to the BH model reviewed in the previous chapter. However, we modify the BH model by taking into account some notable macroeconomic features of the Indonesian economy. We also explain the choice of variables that we are going to employ in the Indonesian SSMM. Finally, we end the chapter with the specification of policy rules based on our understanding of the conduct of monetary policy in Indonesia, most notably during the Asian financial crisis and the period thereafter, which has been discussed in Chapter 2.