Academic journal article Journal of Southeast Asian Economies

The Narrow Money Demand Behaviour in Indonesia, 1970-2005

Academic journal article Journal of Southeast Asian Economies

The Narrow Money Demand Behaviour in Indonesia, 1970-2005

Article excerpt

I. Introduction

Since the currency crisis during 1997-99 Indonesia has introduced a wide range of institutional reforms and redirected monetary policy towards maintaining price and exchange rate stability (Alamsyah et al. 2001; Bank Indonesia 2005; Goeltom 2005). During 1997-2004 Bank Indonesia (central bank of Indonesia) conducted monetary policy through a "rule-based monetary base targeting" under the IMF structural adjustment programmes (Anglingkusumo 2002; Bank Indonesia 2005). Although the monetary base targeting was not strictly enforced, the inflation rate decreased from about 100 per cent in 1998 to a single digit by 2000. Indonesia also maintained reasonable price and exchange rate stability during the next five years. On July 2005 Bank Indonesia switched from monetary to inflation targeting. This was a switch from the use of the monetary base as an instrument under "inflation targeting lite" to the Bank Indonesia interest rate as an alternative instrument under "full-fledged inflation targeting" (Bank Indonesia 2005).

Such evolution of monetary policy in Indonesia has been in the lines adopted by other countries in the region such as South Korea and Thailand. However the question remains whether Indonesia's adoption of full-fledged inflation targeting was premature because it is yet to fulfil the requirements of inflation targeting. The absence of developed money and capital markets and Bank Indonesia's frequent intervention in the foreign exchange markets to stabilize the exchange rates are a matter of concern. It appears that Indonesia's adoption of inflation targeting was reactive, in the sense that it was in response to the "alleged" breakdown of monetary relations implicit in monetary targeting. For example, researchers in Bank Indonesia suggest that the main reason for the switch from monetary to inflation targeting was the difficulty in controlling the growth of the monetary base, which exhibited an erratic behaviour due to external sector developments (1) (Alamsyah et al. 2001; Boediono 2002; Bank Indonesia 2005). Bank Indonesia (2005) and other researchers (Grenville 2000a, 2000b) have also suggested that the relationships between the growth rate of the monetary base and the objective of monetary policy (inflation) have become unstable since the currency crisis. (2) Both are contentious issues. (3) Therefore the debate on monetary policy in Indonesia remains whether the money demand function has become unstable and/ or the relationship between the money supply growth and inflation has weakened, ff the money demand function remains stable and/or the money growth rate becomes the primary (if not the sole) determinant of inflation, the money growth targeting becomes equivalent to inflation targeting provided that the exchange rates float freely. (4) Indonesia may then return to monetary targeting, which has advantages over a full-fledged inflation targeting in a relatively high inflationary country such as Indonesia. (5)

This paper re-examines the issue of stability of the narrow money demand function in Indonesia with annual data for the period 1970-2005. This sample period of study includes the post-crisis data for six years (2000-2005). This allows for an investigation of the money demand behaviour over a sample period that covers varied economic and political environments. One of the requirements of a stable money demand function is that it includes a small number of key arguments, which can predict money demand even when an economy passes through a turbulent period. The paper is developed around this theme.

The remainder of the paper is organized as follows. Section II specifies a partial adjustment model of narrow money demand in an open-economy context and selects variables for estimation of the model with Indonesian data. Section III reports the regression results and selects an empirically parsimonious model for further analysis, including ex-post forecasting. …

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