Central bank credibility and monetary policy in Indonesia

Abstract

This paper examines the role of central bank credibility in achieving an inflation target and proposes monetary policy rules for Indonesia. Towards that end, we construct and estimate a forward-looking small scale macroeconomic model (SSMM) of the Indonesian economy by adapting the theoretical underpinnings of the well-known Batini-Haldane model, along with the Taylor policy rule. Our results indicate that it is crucial for the Indonesian central bank to bolster its credibility in order to achieve a lower inflation rate. The inflation-output volatility trade-off frontier we derived from the SSMM shows that a monetary policy rule that targets both inflation and output gaps will result in less macroeconomic volatility. We also found that the inclusion of the exchange rate into the rule as an additional feedback variable warrants consideration in the future course of monetary policy management. © 2006 Society for Policy Modeling.