ProdukHukum BankIndonesia
How and How Much
Can Monetary Policy Stabilize
the Impacts of Climate Change
Shocks Preemptively?
The Indonesian Case
August 2008
John Junggun Oh
Director of Research, South East Asian Central Banks, Research
and Training Centre (The SEACEN Centre)
The views expressed herein are absolutely those of the author and do not
necessarily reflect those of the SEACEN Centre or the Bank of Korea
8/5/2008
John Junggun Oh
1
Impacts of Climate Change Shocks
• A decrease in the potential capacity of growth
– A decline in capital stocks, labor supply, and total factor productivity
• A rise in the inflation rate
– an increase in the import prices of food and then, as a consequence, a
rise in wage rate
• A decrease in capital inflows
• Deterioration of exports and thus a decrease in economic
growth
– a slowdown of global economic growth
8/5/2008
John Junggun Oh
2
Climate Change Effects on
AS AD curve and Phillips curve
8/5/2008
John Junggun Oh
3
New Optimal Point on the Phillips Curve
8/5/2008
John Junggun Oh
4
Incorporation of Climate Change Shocks
into the Monetary Policy Framework
Climate changes
→ potential growth
→ global economic growth → current account →economic growth
→exchange rate
→ capital flows → potential growth
→exchange rate →current account→ economic growth
→ interest rate → economic growth
→inflation
→ global food price (with ex. rate) →domestic food price→ wage →inflation
→ import price →inflation
8/5/2008
John Junggun Oh
output gap
interest rate
inflation
5
Monetary Policy Framework
New Keynesian Model
•
Policy reaction function of the central bank
int=c(1)+c(2)* (infla(2)-inflatarget) +c(3)*gdpgaprate(1) +c(4)*lnex+c(5)*((
infla(2)-inflatarget)* gdpgaprate(1))+c(6)*int(-1)
•
Non-linear Phillips curve
infla=c(7)+ c(8)*gdpgaprate(-2)+c(9)*gdpgaprate(-2)^2+c(10)*lnwage(1)+c(11)*lnwage(-2)+c(12)*lnimp(-1)+c(13)*lnex(-3)+c(14)*infla(-1)
•
IS curve
lngdp=c(15)+c(16)*(int(-3)-infla(-2))+c(17)*lnex(-6)+c(18)*lngdp(-1)
8/5/2008
John Junggun Oh
6
Other Equations
to incorporate Climate Changes
•
Wage rate equation
lnwage=c(19)+c(20)*gdpgaprate(-1)+c(21)*lnfoodd(-4)+c(22)*lnwage(-1)
•
Domestic food price equation
lnfoodd=c(23)+c(24)*lnex(-1)+c(25)*lnfoodg(-1)+c(26)*lnfoodd(-1)
•
Current account equation
ca=c(27)+c(28)*lngdp(-3)+c(29)*lngdpg(-3)+c(30)*lnex(-4)+c(31)*ca(-1)
•
Import price equation
lnimp=c(37)+c(38)*lnex+c(39)*lnfoodg(-1)+c(40)*lnimp(-1)
•
Exchange rate equation
lnex=c(32)+c(33)*ca(-1)+c(34)*ka(-1)+c(35)*lnexjpus+c(36)*lnex(-1)
8/5/2008
John Junggun Oh
7
Simulation (2008~2011)
•
Baseline without Climate Change Shocks
•
Simulation with Climate Change Shocks
– World food price increases by 20% from 2008 to 2009, 30 % from 2010, and
40% in 2011 against the baseline forecast.
– World real GDP decreases by 2 % from 2008~2011 against the baseline
forecast.
– Indonesian real potential GDP decreases by 1% from 2008~2011 against the
baseline forecast.
– Capital inflows annually decrease US$ 100 million from 2008~2009, and US$
200 million from 2010~2011.
8/5/2008
John Junggun Oh
8
Exchange Rates by Scenario
12000
Due to an
assumed
decrease in
capital inflows,
11000
10000
Indonesian
rupiah is
forecasted to be
depreciated
9000
in contrast to the
expected
appreciation of
the baseline
scenario
exchange rate
forecast.
8000
7000
6000
ex_actual
8/5/2008
ex_baseline
ex_senario
John Junggun Oh
9
c u rre n t ac c o u n t/g d p ratio b y s c e n ario
0.2
0.15
0.1
0.05
-0.05
2 0 0 0 Q1
2 0 0 0 Q3
2 0 0 1 Q1
2 0 0 1 Q3
2 0 0 2 Q1
2 0 0 2 Q3
2 0 0 3 Q1
2 0 0 3 Q3
2 0 0 4 Q1
2 0 0 4 Q3
2 0 0 5 Q1
2 0 0 5 Q3
2 0 0 6 Q1
2 0 0 6 Q3
2 0 0 7 Q1
2 0 0 7 Q3
2 0 0 8 Q1
2 0 0 8 Q3
2 0 0 9 Q1
2 0 0 9 Q3
2 0 1 0 Q1
2 0 1 0 Q3
2 0 1 1 Q1
2 0 1 1 Q3
0
caratio_actual
8/5/2008
caratio_baseline
John Junggun Oh
caraatio_senario
As a result, the
current account is
expected to
improve in the
short-term
compared with the
baseline scenario
current account
forecast,
but, due to the
assumed
slowdown of the
global economy,
its trend is
expected to
decline in the longrun.
10
GDP Gap Rate by Scenario
4
Due to the
declining trend
of the current
account,
2
0
the GDP gap
rate is
forecasted to
record
considerable
minus level,
-2
-4
which shows
the possibility
of substantial
impacts on
economic
growth.
-6
-8
-10
gdpgaprate_actual
8/5/2008
gdpgaprate_baseline
gdpgaprate_senario
John Junggun Oh
11
Inflation Rate by Scenario
In spite of shrinkage of
demand due to the
considerable minus GDP
gap rate,
20
18
16
the inflation rate is
forecasted to show an
increasing trend, in
contrast to the expected
declining trend in the
baseline scenario,
14
12
10
due to a high rise in
domestic food prices
resulted from the
assumed surge in world
food prices
8
6
4
and expected
depreciation of
Indonesian rupiah,
2
0
and, a consequent
increase in wage rates.
infla_actual
8/5/2008
infla_baseline
infla_senario
John Junggun Oh
12
Inflation Target Rate by Scenario
14
In spite of an
increasing trend of
the inflation rate,
12
due to the
considerable minus
GDP gap rate,
10
8
the level of the
target rate of
inflation could be
maintained at the
higher level
compared with the
baseline scenario
target rate of
inflation.
6
4
2
inflatarget_baseline
8/5/2008
11
11
q3
q1
20
q3
20
10
20
10
q1
q3
20
20
09
09
q1
q3
20
q1
08
08
20
Q3
20
07
Q1
20
Q3
07
20
06
Q1
20
06
20
05
Q3
Q1
20
Q3
05
20
04
20
04
Q1
Q3
20
03
20
03
Q1
Q3
20
02
02
20
Q3
20
01
01
Q1
20
Q3
20
00
00
Q1
20
20
Q1
0
inflatarget_senario
John Junggun Oh
13
Interest Rate by Scenario
20
As a
consequence,
18
16
the level of the
interest rate is
forecasted to
maintain at the
slightly lower
level
14
12
10
8
compared with
the baseline
scenario
interest rate
forecast.
6
4
2
0
int_actual
8/5/2008
int_baseline
int_senario
John Junggun Oh
14
Exchange rate policy
• Exchange rate policy, for instance,
appreciation of Indonesian rupiah, could be
recommended to contain the rising inflation
pressure,
• but in this case, the forecasted declining
current account and economic growth could
be deteriorated more.
8/5/2008
John Junggun Oh
15
Identification of the optimal target rate of
inflation and the target rate of interest
•
The levels of data of the simulation results may not be exactly correct since
the simulation was done based on the relatively simple assumptions.
•
The results show that climate change shocks will provide the central bank
with very tough challenges
– how to keep the commitment to price stability on the one hand and how much to
take the possible worsening economic growth and employment into account.
•
It will be important issues for the central bank to identify the optimal target
rate of inflation and the target rate of interest to harmonize the rising inflation
and declining economic growth,
– that is, to identify the optimal point on the newly shifted Phillips curve, which need
much more rigorous analysis.
8/5/2008
John Junggun Oh
16
Monetary Policy Guidelines for Climate Change
Shocks
•
First round impacts of climate change shocks on the economy, in particular,
impacts on the potential capacity of growth, world economic growth, world
food prices, and capital flows, if necessary, in consultation with environmental
specialists.
•
Second round impacts on exchange rates, domestic food prices, wage rates,
import prices and inflation rates on the one hand, and the current account,
economic growth on the other hand.
•
The optimal target rate of inflation based on the studies on the impacts on the
growth and inflation rate,
•
Ultimately preemptive forecast of GDP gap rate and inflation gap, which are
important variables for the formulation of the monetary policy.
•
Finally preemptive estimation of the optimal rate of interest to harmonize the
inflation rate and economic growth.
8/5/2008
John Junggun Oh
17
Core inflation rate
•
Since climate change shocks are largely supply-side shocks, it could be
desirable to examine whether core inflation rate or underlying rate of
inflation excluding foods and energy prices could be a reference indicator
of the inflation rate for the monetary policy.
– Core inflation rate may be useful to overcome the limitations of the monetary
policy as a short-term demand management stabilization policy, in particular, in
the period of rising food prices
•
If the difference between the headline inflation and core inflation is
considerable, and the public has no deep understanding on the core
inflation rate,
– the credibility problem of the central bank may take place. In such cases,
communication between the central bank and the public become more
important.
8/5/2008
John Junggun Oh
18
Policy Coordination with other
Stabilization Policies
• Climate change shocks also need huge fiscal
expenditures,
– which naturally affect the financial market and the
monetary policy, and,
• Coordination with other stabilization policies
are needed as well
8/5/2008
John Junggun Oh
19
Can Monetary Policy Stabilize
the Impacts of Climate Change
Shocks Preemptively?
The Indonesian Case
August 2008
John Junggun Oh
Director of Research, South East Asian Central Banks, Research
and Training Centre (The SEACEN Centre)
The views expressed herein are absolutely those of the author and do not
necessarily reflect those of the SEACEN Centre or the Bank of Korea
8/5/2008
John Junggun Oh
1
Impacts of Climate Change Shocks
• A decrease in the potential capacity of growth
– A decline in capital stocks, labor supply, and total factor productivity
• A rise in the inflation rate
– an increase in the import prices of food and then, as a consequence, a
rise in wage rate
• A decrease in capital inflows
• Deterioration of exports and thus a decrease in economic
growth
– a slowdown of global economic growth
8/5/2008
John Junggun Oh
2
Climate Change Effects on
AS AD curve and Phillips curve
8/5/2008
John Junggun Oh
3
New Optimal Point on the Phillips Curve
8/5/2008
John Junggun Oh
4
Incorporation of Climate Change Shocks
into the Monetary Policy Framework
Climate changes
→ potential growth
→ global economic growth → current account →economic growth
→exchange rate
→ capital flows → potential growth
→exchange rate →current account→ economic growth
→ interest rate → economic growth
→inflation
→ global food price (with ex. rate) →domestic food price→ wage →inflation
→ import price →inflation
8/5/2008
John Junggun Oh
output gap
interest rate
inflation
5
Monetary Policy Framework
New Keynesian Model
•
Policy reaction function of the central bank
int=c(1)+c(2)* (infla(2)-inflatarget) +c(3)*gdpgaprate(1) +c(4)*lnex+c(5)*((
infla(2)-inflatarget)* gdpgaprate(1))+c(6)*int(-1)
•
Non-linear Phillips curve
infla=c(7)+ c(8)*gdpgaprate(-2)+c(9)*gdpgaprate(-2)^2+c(10)*lnwage(1)+c(11)*lnwage(-2)+c(12)*lnimp(-1)+c(13)*lnex(-3)+c(14)*infla(-1)
•
IS curve
lngdp=c(15)+c(16)*(int(-3)-infla(-2))+c(17)*lnex(-6)+c(18)*lngdp(-1)
8/5/2008
John Junggun Oh
6
Other Equations
to incorporate Climate Changes
•
Wage rate equation
lnwage=c(19)+c(20)*gdpgaprate(-1)+c(21)*lnfoodd(-4)+c(22)*lnwage(-1)
•
Domestic food price equation
lnfoodd=c(23)+c(24)*lnex(-1)+c(25)*lnfoodg(-1)+c(26)*lnfoodd(-1)
•
Current account equation
ca=c(27)+c(28)*lngdp(-3)+c(29)*lngdpg(-3)+c(30)*lnex(-4)+c(31)*ca(-1)
•
Import price equation
lnimp=c(37)+c(38)*lnex+c(39)*lnfoodg(-1)+c(40)*lnimp(-1)
•
Exchange rate equation
lnex=c(32)+c(33)*ca(-1)+c(34)*ka(-1)+c(35)*lnexjpus+c(36)*lnex(-1)
8/5/2008
John Junggun Oh
7
Simulation (2008~2011)
•
Baseline without Climate Change Shocks
•
Simulation with Climate Change Shocks
– World food price increases by 20% from 2008 to 2009, 30 % from 2010, and
40% in 2011 against the baseline forecast.
– World real GDP decreases by 2 % from 2008~2011 against the baseline
forecast.
– Indonesian real potential GDP decreases by 1% from 2008~2011 against the
baseline forecast.
– Capital inflows annually decrease US$ 100 million from 2008~2009, and US$
200 million from 2010~2011.
8/5/2008
John Junggun Oh
8
Exchange Rates by Scenario
12000
Due to an
assumed
decrease in
capital inflows,
11000
10000
Indonesian
rupiah is
forecasted to be
depreciated
9000
in contrast to the
expected
appreciation of
the baseline
scenario
exchange rate
forecast.
8000
7000
6000
ex_actual
8/5/2008
ex_baseline
ex_senario
John Junggun Oh
9
c u rre n t ac c o u n t/g d p ratio b y s c e n ario
0.2
0.15
0.1
0.05
-0.05
2 0 0 0 Q1
2 0 0 0 Q3
2 0 0 1 Q1
2 0 0 1 Q3
2 0 0 2 Q1
2 0 0 2 Q3
2 0 0 3 Q1
2 0 0 3 Q3
2 0 0 4 Q1
2 0 0 4 Q3
2 0 0 5 Q1
2 0 0 5 Q3
2 0 0 6 Q1
2 0 0 6 Q3
2 0 0 7 Q1
2 0 0 7 Q3
2 0 0 8 Q1
2 0 0 8 Q3
2 0 0 9 Q1
2 0 0 9 Q3
2 0 1 0 Q1
2 0 1 0 Q3
2 0 1 1 Q1
2 0 1 1 Q3
0
caratio_actual
8/5/2008
caratio_baseline
John Junggun Oh
caraatio_senario
As a result, the
current account is
expected to
improve in the
short-term
compared with the
baseline scenario
current account
forecast,
but, due to the
assumed
slowdown of the
global economy,
its trend is
expected to
decline in the longrun.
10
GDP Gap Rate by Scenario
4
Due to the
declining trend
of the current
account,
2
0
the GDP gap
rate is
forecasted to
record
considerable
minus level,
-2
-4
which shows
the possibility
of substantial
impacts on
economic
growth.
-6
-8
-10
gdpgaprate_actual
8/5/2008
gdpgaprate_baseline
gdpgaprate_senario
John Junggun Oh
11
Inflation Rate by Scenario
In spite of shrinkage of
demand due to the
considerable minus GDP
gap rate,
20
18
16
the inflation rate is
forecasted to show an
increasing trend, in
contrast to the expected
declining trend in the
baseline scenario,
14
12
10
due to a high rise in
domestic food prices
resulted from the
assumed surge in world
food prices
8
6
4
and expected
depreciation of
Indonesian rupiah,
2
0
and, a consequent
increase in wage rates.
infla_actual
8/5/2008
infla_baseline
infla_senario
John Junggun Oh
12
Inflation Target Rate by Scenario
14
In spite of an
increasing trend of
the inflation rate,
12
due to the
considerable minus
GDP gap rate,
10
8
the level of the
target rate of
inflation could be
maintained at the
higher level
compared with the
baseline scenario
target rate of
inflation.
6
4
2
inflatarget_baseline
8/5/2008
11
11
q3
q1
20
q3
20
10
20
10
q1
q3
20
20
09
09
q1
q3
20
q1
08
08
20
Q3
20
07
Q1
20
Q3
07
20
06
Q1
20
06
20
05
Q3
Q1
20
Q3
05
20
04
20
04
Q1
Q3
20
03
20
03
Q1
Q3
20
02
02
20
Q3
20
01
01
Q1
20
Q3
20
00
00
Q1
20
20
Q1
0
inflatarget_senario
John Junggun Oh
13
Interest Rate by Scenario
20
As a
consequence,
18
16
the level of the
interest rate is
forecasted to
maintain at the
slightly lower
level
14
12
10
8
compared with
the baseline
scenario
interest rate
forecast.
6
4
2
0
int_actual
8/5/2008
int_baseline
int_senario
John Junggun Oh
14
Exchange rate policy
• Exchange rate policy, for instance,
appreciation of Indonesian rupiah, could be
recommended to contain the rising inflation
pressure,
• but in this case, the forecasted declining
current account and economic growth could
be deteriorated more.
8/5/2008
John Junggun Oh
15
Identification of the optimal target rate of
inflation and the target rate of interest
•
The levels of data of the simulation results may not be exactly correct since
the simulation was done based on the relatively simple assumptions.
•
The results show that climate change shocks will provide the central bank
with very tough challenges
– how to keep the commitment to price stability on the one hand and how much to
take the possible worsening economic growth and employment into account.
•
It will be important issues for the central bank to identify the optimal target
rate of inflation and the target rate of interest to harmonize the rising inflation
and declining economic growth,
– that is, to identify the optimal point on the newly shifted Phillips curve, which need
much more rigorous analysis.
8/5/2008
John Junggun Oh
16
Monetary Policy Guidelines for Climate Change
Shocks
•
First round impacts of climate change shocks on the economy, in particular,
impacts on the potential capacity of growth, world economic growth, world
food prices, and capital flows, if necessary, in consultation with environmental
specialists.
•
Second round impacts on exchange rates, domestic food prices, wage rates,
import prices and inflation rates on the one hand, and the current account,
economic growth on the other hand.
•
The optimal target rate of inflation based on the studies on the impacts on the
growth and inflation rate,
•
Ultimately preemptive forecast of GDP gap rate and inflation gap, which are
important variables for the formulation of the monetary policy.
•
Finally preemptive estimation of the optimal rate of interest to harmonize the
inflation rate and economic growth.
8/5/2008
John Junggun Oh
17
Core inflation rate
•
Since climate change shocks are largely supply-side shocks, it could be
desirable to examine whether core inflation rate or underlying rate of
inflation excluding foods and energy prices could be a reference indicator
of the inflation rate for the monetary policy.
– Core inflation rate may be useful to overcome the limitations of the monetary
policy as a short-term demand management stabilization policy, in particular, in
the period of rising food prices
•
If the difference between the headline inflation and core inflation is
considerable, and the public has no deep understanding on the core
inflation rate,
– the credibility problem of the central bank may take place. In such cases,
communication between the central bank and the public become more
important.
8/5/2008
John Junggun Oh
18
Policy Coordination with other
Stabilization Policies
• Climate change shocks also need huge fiscal
expenditures,
– which naturally affect the financial market and the
monetary policy, and,
• Coordination with other stabilization policies
are needed as well
8/5/2008
John Junggun Oh
19