Monetary policy in managing Inflation in Indonesia: a linear rational expectations model

Abstract

This paper assesses the (in)effectiveness of monetary policy in managing inflation by employing a linear rational expectations framework. Inflation targeting is currently the main flagship of the Indonesian monetary authority and such objective is carried out within a nearly perfect open economy which is succeptible to changes in external economic situations. We consider a macroeconomic model described by a couple of structural equations which consist of several exogenous variables as shock generators. The model is then solved by implementing undetermined coefficient methods. A series of simulation based on the state space representation of the model with respect to an impulse response function is performed to highlight some of key features of current inflation trends. It is shown that monetary policies (interest rate as operating policy) can effectively affect inflation in the short run, but it has limited power in the longer run. Furthermore, its effectiveness is hampered by the so called fiscal dominance and adverse global shocks. Thus, under such a situation it would be difficult for the monetary authority to set a credible inflation target.