Frictions and empirical fit in a DSGE model for Indonesia

I build a small-scale dynamic stochastic general equilibrium (DSGE) model for Indonesia and assess which structural features of the model are consistent with actual data. I show that the best-fitting model does not include habit formation or backward-looking price indexation, which are widely assumed features in standard DSGE models. Money-holding friction, however, is found to be an important feature. When these features are assumed to be present, I find that the degrees of habit formation and price indexation decline after full-fledged adoption of the inflation targeting framework in Indonesia. This implies that agents of the economy believe that Bank Indonesia’s monetary policy is credible in achieving its inflation target. When using a large-scale DSGE model for policy analysis, central banks must evaluate which frictions should be included.