Central bank credibility and monetary policy: Evidence from small scale macroeconomic model of Indonesia

Abstract

Macroeconomic models are usually developed in a large framework that comprises hundreds of equations. Some pitfalls, however, are inevitable such as a partial failure of forecasts and some theoretical shortcomings of a large macroeconomic model (Lawson 1992 and Wallis 1989). In the early 1990s, small scale macroeconomic model (SSMM) emerged as an alternative tool for comparing the results obtained from larger macroeconomic models. An SSMM is deliberately kept small with a substantial level of aggregation, thus forcing the model to focus on key issues rather than to look at excessive details in the economy. An SSMM is characterized by a compact system of equations that describe the behaviour of key macroeconomic aggregates. In this paper, we develop an SSMM of a forward-looking nature that captures the island-wide dynamics of the Indonesian economy which is potentially useful for carrying out policy analysis, and in particular to analyze the effects from monetary policy. The goal is to better understand the options available to Indonesia policymakers to deal with economic shocks. Batini-Haldane (BH 1999) model will be used as theoretical underpinnings in our study along with several choices of policy rules such as the well-known Taylor rule (1993) and the McCallum rule for money supply (1988) to complete the Indonesian SSMM. The BH model is appealing because of the forward-looking feature that captures the dynamics of the economy by taking into account saving behaviour of rational agents, thus ensuring the macroeconomic model that we built is immune to Lucas' critique. Based on this Indonesian SSMM, we will conduct deterministic and stochastic econometric simulation exercises to capture the essence of monetary policy transmission mechanism in the Indonesian economy. Specifically, we will look at the role of the central bank's credibility in ensuring the achievement of the inflation target. It is found that, in the case of Indonesia, no credibility at all is highly undesirable for the central bank but we show that at least for a given level of credibility, inflation target can be achieved in much faster time. Furthermore, we will experiment with two types of monetary policy rules (Taylor and McCallum) and compare their relative merits in mitigating output and inflation variability in the Indonesian economy. It is found that both simple rules perform equally well but we suggest the central bank to adopt Taylor rule in recent years to support the move towards inflation targeting. Policy frontier concerning the variability of output and inflation as we vary the relative importance of these macroeconomic variables in the policy reaction function will also be discussed thoroughly. The importance of this study is to highlight the usefulness of a small scale macroeconomic model in analyzing key issues for an economy as large as Indonesia. Given the complexity of the dynamics in the Indonesian monetary policy management and transmission, our model has proven its capability to deliver some crucial policy implications that will be useful for policy-makers in Indonesia and in the region alike. Through our econometric exercise, we found that the small-scale macroeconomic model we have built is able to capture the short- to medium-term economic dynamics in Indonesia. Credibility of the Central Bank is very important for achieving sustainable non-inflationary economic growth. This finding supports the new Central Bank Act in 1999 that requires BI to announce the inflation target on a regular basis to the public as to ensure its accountability and to reduce the inflation volatility.