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

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

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

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 +

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

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

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

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

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.

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.

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

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

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

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

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 1000.00

The Formula for Multiple Deposit Creation

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.

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

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.

Money Multiplier

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

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

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

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

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

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

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)

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 ) *)

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

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

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.

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

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