1. Monetary Policy in Indonesia
Program MM
STIE Perbanas
Monetary Policy in Indonesia

2. Scope of discussion How the monetary sector affects the economy?
Demand and supply of money
Transmission of monetary policy
Monetary policy in the long-run
Policy conflicts
Money Supply Process
Framework of monetary policy
Monetary Operations

3. How the monetary sector affects the economy
How the monetary sector affects the economy? (Interrelationship among macroeconomic accounts)
REAL SECTOR
Consumption
Investment
Export
Import
EXTERNAL SECTOR
Current Account
Export
Import
Transfer
Income
Capital & Financial Transaction
Direct Investment
Financial flows
Government
Private
Official foreign reserves
GOVERNMENT SECTOR
Fiscal (APBN)
Revenues, incl. grant
Expenditures
Primary balances
Financing
Domestic
External Luar Negeri
MONETARY SECTOR
Monetary Authority
Foreign assets net
Domestic assets net
Net Claim on Government
Commercial Banks
Base money
Aggregate demand:
Y = C + I + G + (X-M)
Money supply

4. Supply and Demand for Money
Supply of money : Ms = mm * Mo
determined by the central bank.
Demand for money : Md = f (GDP, CPI)
determined by people or money holder
Definition of money:
Mo = C + Rb where Mo = monetary base (high-powered money) ; C = Currency (bank notes);
Rb = Bank reserves (banks’ account at the central bank + cash in vault)
M1 = C + DD where DD = Demand deposits (checking accounts, giro accounts)
M2 = C + DD + TD where TD = Saving and Time deposits
M3 = M2 +

5. Supply and Demand for Money - Equilibrium
Supply of money is determined by the central bank monetary policy, and therefore the supply curve is vertical.
Demand for money is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds.
Equilibrium: The money interest will gravitate the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the central bank has supplied (supply).
Interest rate Ms
At i*, people are
willing to hold the
money supply set
by the central bank
Excess
supply i2 i* Md i3
Excess
demand
Quantity
of Money Qs

6. Transmission of monetary policy
The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy.
The impact of a shift in monetary policy is generally transmitted through intrest rates, exchange rates, and assets prices.
An expansionary monetary policy will increase supply of loanable funds and put downward pressure on real interes rates. As real interest rates falls, aggregate demand increases (to AD2), leading to a short run increase in output (Y1 to Y2…..and prices (from P1 to P2)… inflation
Real
Interest rate
Price level S1 S2
AS1 P2
AD2 P1 r2
AD1 D
Quantity of
Loanable funds
Goods/services
(real GDP)
Y1 Y2 Q

7. Monetary policy in the long-run
If the impact of an increase in AD accompanying expansionary policy is felt when the economy operating below capacity, the policy will help direct the economy back to a long-run full employment output equilibrium (Yf).
In contrast, if the demand-stimulus effects are imposed on an economy already at full employment (Yf), they will lead to excess demand, higher prices,and temporarily higher output (Y2).
In the long-run, the strong demand will push up resources prices, shifting back short-run AS.
The price level rises to P3 (from P2) and output back to Yf once again.
LRAS
LRAS
Price
level
Price
Level
SRAS2
SRAS1
SRAS1 P3 e3 P2 e2 P2 e2
AD2
AD2 P1 e1 P1 e1
AD1
AD1
Goods/services
(real GDP)
Goods/services
(real GDP)
Yf Y2 Y1 Yf

8. The Mechanism of monetary transmission
Direct monetary transmission 8
Money
Money Supply-Demand
Credit channels
Bank lending
Loan Supply-Demand
Firms balance sheet
Ext. Financing, Leverage
Interest rate channel
Cost of capital
Monetary
Policy:
Base money
Interest rate
Final
Objective:
Prices
Output
Real interest
Substitution effect
Income effect
Asset price channel
Net exports-cap.flows
Exchange rate
Imported prices
Tobin’s q
Equity-Property prices
Wealth effect
Expectation channel
Expectation
Real interest rate
Moral hazard,
Adverse selection
Uncertainty

9. Policy conflicts
Theoretically, in the short-term there is trade-off between achieving targets of containing inflation and promoting output
Phillips Curve:  =  (y – y*)
Long-run full employment vs below capacity
However, there is growing research evidence that maximum employment, sustainable economic growth, and price stability can be compatible with one another in the longer run.
Expantionary monetary policy leads to promote economic activities, but would in turn push inflation upward  A need to strike a balance between monetary and fiscal policy and other macroeconomic policies  policy coordination.

10. Monetary policy in the long-run
The quantity theory of money
M * V = P * Y where M = money; V = velocity of money;
P = price; Y = income
If V and Y are constant, than an increase in M would lead to a proportional increase in P.
Implication:
In the long run, the primary impact of monetary policy will be on prices rather than on real output
When expansionary monetary policy leads to rising prices, monetary authorities eventually anticipate the higher inflation and build it into their choices
As it happens, nominal interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

11. Bank Indonesia’s Balance Sheet
Money Suppy Process
Player in the money supply process:
Central bank (Bank Indonesia)
Banks (depository institutions)
Depositors (individuals and institutions)
Banking System
Bank Indonesia’s Balance Sheet
Assets
Liabilities
Reserves
Deposits
Government Securities
Currency in circulation
Government securities
Borrowings
Banks’ giro/ reserves
SBIs

12. Shifts from Deposits into Currency
Nonbank Public
Banking System
Assets
Liabilities
Checkable deposits
100
Reserves
- 100
Currency
+ 100
Bank Indonesia
Assets
Liabilities
Currency in circulation
+ 100
Reserves
100
Net effect on monetary liabilities is zero

13. Deposit Creation: Single Bank
Bank BCA
Assets
Liabilities
Securities
-100
Checkable deposits
+100
Reserves
Loans
Bank BCA
Assets
Liabilities
Securities
-100
Loans
+100

14. Deposit Creation: The Banking System
Bank A
Assets
Liabilities
Reserves
100
Checkable deposits 10
+100
Loans
+90
Bank B +9
+81

15. Creation of Deposits (assuming 10% reserve requirement and a Rp 100 increase in reserves)
Bank
Increase in Deposits (Rp)
Increase in Loans (Rp)
Increase in reserves (Rp)
Bank BCA
0.00
100.00 A
90.00
10.00 B
81.00
9.00 C
72.90
8.10 D
65.61
7.29 E
59.05
6.56 F
53.14
5.91
Total for all banks

16. The Formula for Multiple Deposit Creation

17. Factors that Determine the Money Supply
Changes in the required reserves ratio
The money supply is negatively related to the required reserve ratio.
Changes in currency holdings
The money supply is negatively related to currency holdings.
Changes in excess reserves
The money supply is negatively related to the amount of excess reserves.

18. The Money Multiplier
Define money as currency plus checkable deposits: M1
Link the money supply (M) to the monetary base (MB) and let m be the money multiplier
Ms = mm x Mo --- mm = Ms/Mo
mm¹ = M1/Mo (narrow money multiplier)
mm² = M2/Mo (broad money multiplier)
Assume that the desired holdings of currency C and excess reserves ER grow proportionally with checkable deposits D, then
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio

19. Money Multiplier
The total amount of reserves ( R ) = required reserves (RR) + excess reserve( ER)
RR = required reserve ratio (r ) x third party deposits (D)
R = (r x D ) + ER
Bank Indonesia sets r = 5%
The monetary base MB equals currency (C) plus reserves (R):
MB = C + R = C + (r x D) + ER
Equation reveals the amount of the monetary base needed to support the existing amounts of third party deposits, currency and excess reserves.

20. Money Multiplier

21. Reserve requirement
In the most countries, all depository financial institutions are required to conform to the deposit reserve requirements set by the central bank.
Changes in reserve requirements are a very potent, though little-used tool.
Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.
An increase in deposit reserve requirements
decreases the deposit and money multipliers, slowing the growth of money, deposits and loans
reduces the amount of excess legal reserves - institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves
increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies

22. Framework of monetary policy in Indonesia
Operational target
Strategic target
Ultimate target
Instruments
Operational
target
Intermediate
target
- OMO Interest rates (ST) - Interest rates (LT) Inflation
- Reserve requirement - Base money M1, M2, kredit (since Act # 23/1999)
- Discount window Interest rates
- Moral suasion (BI rate)
Nominal
“Anchor”
- Exchange rate
Monetary variables
Inflation (inflation targeting)
Nominal output
No explicit nominal anchor
Targets

23. Inflation Targeting “A Framework, Not A Rule”
Monetary
operations
Policy
response
Policy
Indicators
Ultimate
target
Monetary
instruments
BI Rate
Inflation
forecast
Inflation
target +
Liquidity management
Interest rates corridor
Interest rate sstructure
Public welfare
Trade off between inflation & output Inflasi dan Output
Expectation
Exchange rate stability
Other monetary and banking objectives
Output growth
Factors affecting inflation
Linkage among macroecon variables
Monetary trasmission moneter +
Coordination with
Government
Policy
Credibility
Model, research, stat,
expert opinion, judgement
Policy communication
Commitment/Consistency
Building expectation

24. Transmission mechanism of monetary operations
SBI
Auction
Interest
Rate
Domestic
Supply
OMO
FASBI
Domestic
Inflation
Pressures FX
Intervention
Asset
Price
Domestic
Demand
Money
Market
Liquidity
Expectation &
Confidence
INFLATION
Discount
Window
Foreign
Inflation
Pressures
Exchange
Rate RR
Moral Suasion
Indicators :
- M1, M2
- Bank’s Loan
Indicators :
- Import
Price Index
Indicators :
- CPI
- Underlying
Core
- Asset Price
- Other Price
Adm/Non
Trade/Non
Food/Non
Indicative Targets:
Bank reserves
Indicators:
- Money Market Rates
- Deposit Rates
- Lending Rates
- IHSG
- Exchange Rates
Indicators:
- Surveys
- Leadings
- Output Gap

25. Monetary transmission through pricing approach
Market interest
rates
Domestic
demand
Domestic
Inflationary
pressure
Asset prices
Total
demand
Official
Rate
(BI rate)
Net external
demand
Inflation
Expectations/
confidence
Import
prices
Exchange rate

26. Monetary operations
Day-to-day monetary operations mostly conducted through open market operations (OMO), while other instruments such as reserve requirement and moral suasion are rarely used.
Bank Indonesia sets interest rate target (BI rates since July 2005) and conducting OMO by auctioning Bank Indonesia Certificates (SBI) and Government Securities (SUN), intervening in the FX market and open window for deposits facility.
BI rate reflects the stance of monetary policy, that is the level of short-term interest rate BI wishes to maintain in order to achieve inflation target
How open market operations change monetary conditions?
Buying securities Mo
Securities
auction
Selling securities i
M1 & M2
Price
Stability

27. Operational mechanism
SBI auction
Contraction
FASBI/SWBI
OMO Reguler
Reverse Repo SUN*)
Expansion
SBI/SUN Repo
OMO
Fine Tune Contraction
(FTK), Outright sale SUN
Contraction
Sterilisation/Intervention
(sale USD/IDR)
OMO Non Reguler/
Fine Tune Operation
Fine TuneExpansion
(FTE), Outright Buy SUN
Expansion
Sterilisation/Intervention
(buy USD/IDR)

28. Characteristics of instruments
SBI
FASBI
SWBI
SBI Repo *
FTO
Reverse
Repo **
SUN Outright
Impact
Contraction
Reguler
Expansion
Contraction/
Non reguler
Tenor 1
month
3 month
o/n
7 days
14 days –
< 3 month -
Units
Rp 1.000
mio
Rp 500
Max. 25%
o/s SBI
bank
Increment
Rp 100
Rp 50
Rp 100 mio
Mechanism
Auction
Non
auction
Auction/
Non-auction
Interest
rate
result
Pre
determined
PUAS
PUAB o/n /
SBI+200bp
pre-
Pre-
Participants
Bank,
broker
Bank/un it
syariah
Bank ) *)

29. Open market operations
1. Auctions of SBIs and or SUN
2. Deposit facility (FASBI)
3. FX sterilization/intervention
1. SBIs and SUN auction
Based on liquidity forecast, BI sets auction target (in volume) and announce to the market every Tuesday. Conducts weekly (every Wednesday) auction of SBIs, and occationally (non reguler) auction of SUN
Auction SBI-1 month every week, and SBI-3 month once a month
On a daily basis, BI closely oversees market liquidity by forecasting sources and uses of liquidity of commercial banks, in particular the movement of government accounts, changes in foreign reserves, and market condition

30. Open market operations
Auctions of SBIs and or SUN
Deposit facility (FASBI)
FX sterilization/intervention
2. Bank Indonesia deposits facility (FASBI)
On day-to-day, BI provides window facility for banks to deposit their liquidity with maturity o/n to one a week, aiming at smoothing the fluctuation of interbank money market rates.
FASBI rate o/n : BI rate – 200 bps
7 days: BI rate – 500 bps
BI also offers repurchase agreement (repos) on SBI and repos/reverse repos for SUN

31. Open market operations
Auctionsof SBIs and or SUN
Deposit facility (FASBI)
FX sterilization/intervention
3. Foreign exchange sterilization or intervention
As the cashier for the government financial transactions, BI provides FX for the government FX transactions, such as, payments of matured foreign debt, supply of FX for Pertamina originated from budget subsidy.
For managing liquidity in the domestic money market while smoothing the fluctuation of Rp exchange rate, BI occationally engages in selling (or buying?) FX (foreign reserves). This action is called intervention or sterilization.

32. Reverse Repo SUN BANK Announcement BANKS INDONESIA
Banks offer quantity and bid rate (reverse repo rate) during window time
Settlement first leg T+1
BI debits bank’s account equal the amount won
BI credit bank’s security (SUN) account
BANK
INDONESIA
Announcement
Auction RR-SUN (T-1)
BANKS
Second leg (RR-SUN at maturity)
Banks sell back SUN
BI credit bank’s account at the amount settled at the first leg + reverse repo rate
BI debit bank’s SUN account

33. Balance Sheets of Monetary Authority and Monetary System (Monetary Survey)