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Monetary Policy in Indonesia Program MM STIE Perbanas.

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Presentation on theme: "Monetary Policy in Indonesia Program MM STIE Perbanas."— Presentation transcript:

1 Monetary Policy in Indonesia Program MM STIE Perbanas

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 EXTERNAL SECTOR Current Account Export Import Transfer Income Capital & Financial Transaction Direct Investment Financial flows – Government – Private Official foreign reserves REAL SECTOR Consumption Investment Export Import 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 Foreign assets net Domestic assets net Base money Money supply How the monetary sector affects the economy? ( Interrelationship among macroeconomic accounts) Aggregate demand: Y = C + I + G + (X-M)

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). Quantity of Money Interest rate Ms Md QsQs i* At i*, people are willing to hold the money supply set by the central bank Excess supply Excess demand i2i2 i3i3

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 Goods/services (real GDP) Price level AS1 AD1 Y 1 Y 2 P1 AD2 P2 Quantity of Loanable funds Real Interest rate Q r2r2 D S1S1 S2S2

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. Goods/services (real GDP) Price level SRAS 1 AD 1 Y f Y 2 P1P1 AD 2 P2P2 Goods/services (real GDP) Price Level Y1Y1 P2P2 AD 1 SRAS 1 LRAS AD 2 P1P1 YfYf e1e1 e2e2 SRAS 2 LRAS P3P3 e1e1 e2e2 e3e3

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

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 Player in the money supply process: Central bank (Bank Indonesia) Banks (depository institutions) Depositors (individuals and institutions) Money Suppy Process Banking SystemBank Indonesia’s Balance Sheet AssetsLiabilitiesAssetsLiabilities ReservesDepositsGovernment Securities Currency in circulation Government securities BorrowingsBanks’ giro/ reserves SBIs

12 Shifts from Deposits into Currency Nonbank PublicBanking System AssetsLiabilitiesAssetsLiabilities Checkable deposits - 100Reserves- 100Checkable deposits Currency+ 100 Bank Indonesia AssetsLiabilities Currency in circulation Reserves-100 Net effect on monetary liabilities is zero

13 Deposit Creation: Single Bank Bank BCA AssetsLiabilitiesAssetsLiabilities Securities-100Securities-100Checkable deposits +100 Reserves+100Reserves+100 Loans+100 Bank BCA AssetsLiabilities Securities-100 Loans+100

14 Deposit Creation: The Banking System Bank A AssetsLiabilitiesAssetsLiabilities Reserves100Checkable deposits 100Reserves10Checkable deposits +100 Loans+90 Bank B AssetsLiabilitiesAssetsLiabilities Reserves+90Checkable deposits +90Reserves+9Checkable deposits +90 Loans+81

15 Creation of Deposits (assuming 10% reserve requirement and a Rp 100 increase in reserves) BankIncrease in Deposits (Rp) Increase in Loans (Rp) Increase in reserves (Rp) Bank BCA A B C D E F 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 Instruments Operational target Intermediate target Ultimate target Framework of monetary policy in Indonesia Operational targetStrategic target Nominal “Anchor” - Exchange rate - Monetary variables - Inflation (inflation targeting) - Nominal output - No explicit nominal anchor Targets - 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)

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

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

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

26 Monetary operations How open market operations change monetary conditions? Buying securities Mo Securities auction Selling securities i M1 & M2 i Price Stability 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

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

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

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 1.Auctions of SBIs and or SUN 2.Deposit facility (FASBI) 3.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 1.Auctionsof SBIs and or SUN 2.Deposit facility (FASBI) 3.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 T+0 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 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 BANK INDONESIA BANKS Announcement Auction RR-SUN (T-1)

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


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