Econometric Analysis of the Exchange Rate Channel and Monetary Policy Rule: The Case of Indonesia

After the Asian financial crisis, Indonesia changed its exchange rate system from a managed floating to flexible type, allowing market forces greater influence in determining the country's exchange rate. While the managed floating exchange rate system has brought predictable results to a certain extent it has also created new challenges for Indonesian monetary policy. It is quite difficult to propose appropriate policies towards inflation targeting without quantifying the impact of monetary policy. At the same time, identifying possible links between the floating exchange rate and monetary rules is also rather challenging. The objective of this paper is to examine the links between the exchange rate channel and a proper monetary policy rule toward an inflation targeting framework for Indonesia. The paper employs a small macroeconometric model based on the IS-LM-Philips Curve type developed by Batini- Haldane (1999). Our finding is that the exchange rate in Indonesia is becoming less volatile, but both the magnitude changes in the rupiah (Indonesian currency) as well as depreciation are quite high. We also find that in a small open economy such as Indonesia, it is difficult to implement inflation targeting directly without taking exchange rate movements into consideration. Under these circumstances, it is recommended that the Central Bank of Indonesia should apply optimal monetary policy rules to the exchange rate as the reaction function. Optimal monetary policy can better stabilize the whole economy regardless of the fact that using the 'exchange rate into policy' rule does not yield a better value of loss function.