Reaction Function Model of Monetary Policy under Inflation Targeting Framework in Indonesia

Abstract

The study aimed were 1. to test and analyze real GDP lag, real GDP lead, real interest rate and real exchange rate simultaneously and partially affected on output gap; 2. to test and analyze real GDP and SBI interest rate simultaneously and partially affected on real money balance; 3. to test and analyze inflation lead, inflation lag, real GDP lag, real exchange rate lag, real exchange rate lag 2 simultaneously and partially affected on inflation; 4. to test and analyze output gap and inflation gap simultaneously and partially affected on SBI interest rate; 5. to test and analyze output gap, inflation gap and real exchange rate gap simultaneously and partially affected on SBI interest rate; and then 6. to describe reaction function model of opened economy was better than model of closed economy. The study concluded that 1. real GDP lag, real GDP lead, real interest rate and real exchange rate simultaneously significant affected on output gap. Real GDP lag, real interest rate and real exchange rate partially significant affected on output gap, but real GDP lead did not; 2. real GDP and SBI interest rate simultaneously and partially significant affected on real money balance; 3. inflation lead, inflation lag, real GDP lag, real exchange rate lag and real exchange rate lag 2 simultaneously significant affected on inflation. Inflation lead, inflation lag and real GDP lag partially significant affected on inflation, but real exchange rate lag and real exchange rate lag 2 did not; 4. output gap and inflation gap simultaneously significant affected on SBI interest rate. Inflation gap partially significant affected on SBI interest rate, but output gap did not; 5. output gap, inflation gap and real exchange rate gap simultaneously significant affected on SBI interest rate. Inflation gap partially significant affected on SBI interest rate, but output gap and exchange rate gap did not; then 6. reaction function model of opened economy was better than closed economy one, proven that value of social welfare loss function of opened economy model less than value of closed one. Contributions of the study were 1. to enlarge alternative reaction function model of monetary policy; and 2. to prove that both reaction function models needed discretion more than rule considering of low determinant coefficient. Based on the study, it was recommended that: 1. BI should adopt reaction function model of opened economy in formulating the following monetary policy; 2. BI should focused on achieving inflation target through utilizing five pillars policy mix related the study, as follows consistent monetary policy to achieve inflation target, exchange rate policy to control stability of rupiah and communication strategy to support effectiveness of policy; and 3. BI should revitalize monetary instrument of discount window to regulate banking and control low inflation rate.