An econometric model of the Indonesian monetary sector

Abstract

<p>This study develops a monetary policy oriented model for Indonesia consistent with existing institutional setting. Since capital market has not developed yet, banking loan is the main source of external finance for businesses. The bank loan-investment nexus may be the most direct way for monetary policies to affect real sector in such an environment. Accordingly, the model includes commercial bank loan determination and its relationship with investment. The government attempt to sterilize balance of payment and domestic credit expansion by reciprocally changing its deposit at the central bank is captured using a policy reaction function. Private capital flows and trade in services are endogenized. The empirical results confirm that financial availability (bank loans and direct foreign investment) is important for investment, and the government sterilizes partially the affects of balance of payment and domestic credits expansion on money supply. The overall performance of the model is good. Simulation exercises using the model shows that the easy credit policy could increase real gross domestic product and investment. The problem, however, is that it also increases inflation and reduces the central bank foreign exchange reserve. Devaluation, on the other hand, could cause stagnation. It, however, could improve the balance of payment. Devaluation is a costly cure for the balance of payment deficit.</p>