Monetary Policy in Post Crisis Indonesia: Some Empirical Evidence
Yoga Affandi1
Abstract
In the aftermath of the Asian crisis, determining the appropriate monetary
policy has become more complex for small open economy such as Indonesia. The
challenge for policymakers is to establish a new framework for monetary policy after
the collapse of managed floating regimes in 1997. As the central banking law wasenacted in 1999, the inflation targeting framework aimed primarily at promoting pricestability is proposed to put in place as a new framework for monetary policy.
These recent developments clearly increase the need to investigate themonetary process in post crisis Indonesia. This paper examines both long run andshort run relationships as suggested by monetary theory. In long run analysis, weemploy the approach of cointegrating VAR. We identified two cointegrating vectors:
a traditional money demand function and a Fisher effect relationship. In the long run,real money demand as measured by M1 is a function of real output and theopportunity cost of holding money. The existence of Fisher Inflation Parity allows us
to estimate the long run real rate of return.
For short run analysis, we estimate monetary policy reaction function. To
estimate the model, we employ the Generalized Method of Moment (GMM)
approach. As Indonesia is a small open economy, the role of exchange rates could not
be neglected. Thus, we need to investigate how central bank response to exchange
rates. Here, we expand the basic model and investigate the role of exchange rate in themonetary policy reaction function.
The empirical results show that the central bank has put more weight on
inflation as compared to output in its preference. This quantitative evidence clearly
lend support to the view that central bank's main task is to achieve price stability. For
post crisis period, it is also found that the response of interest rate to the expected
inflation was more than one, ensuring the macroeconomic system to stabilize, as thecentral bank did not let the expected inflation to increase. The effectiveness of thispolicy can obviously be seen during the crisis, when monetary authority did increase
the interest rate, as shown by much higher coefficient of the interest rate to theexpected inflation, in order to contain the increase of expected inflation.
The empirical evidence lends quantitative support to implement inflation
targeting as new framework for monetary policy in Indonesia. By inflation targeting,the central bank indirectly reduces the long run real interest rate, thus lowering thelong run inflation rate. The monetary authority needs to use expected inflation as thetarget of monetary policy and to response sufficiently to the expected inflation.
JEL Classification: E43, C50
Key Words: Cointegrating VAR, Monetary Policy Rule, Inflation Targeting1

Author’s affiliation: (1) Faculty of Economics and Politics, University of Cambridge - Cambridge,
United Kingdom, and (2) Bank Indonesia - Jakarta, Indonesia. Correspondence to: ya221@cam.ac.uk.

Correspondence to:
Yoga AFFANDI
Faculty of Economics and Politics
University of Cambridge
Austin Robinson Building
Sidgwick Avenue
Cambridge CB3 9DD
United Kingdom
Tel: (44) 1223 524890
Fax: (44) 1223 335475
E-mail: ya221@cam.ac.uk
affandi_y@yahoo.com