Monetary Policy in Indonesia

Program MMSTIE Perbanas

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

EXTERNAL SECTOR

Current AccountExportImport

TransferIncome

Capital & Financial Transaction

Direct Investment Financial flows

– Government– Private

Official foreign reserves

REAL SECTOR

Consumption Investment Export Import

GOVERNMENT SECTOR

Fiscal (APBN)Revenues, incl. grantExpenditures 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)

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).

Quantityof Money

Interest rate Ms

Md

Qs

i*

At i*, people are willing to hold the money supply set by the central bank

Excesssupply

Excessdemand

i2

i3

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

Y1 Y2

P1AD2

P2

Quantity of Loanable funds

RealInterest rate

Q

r2 D

S1 S2

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

SRAS1

AD1

Yf Y2

P1

AD2P2

Goods/services (real GDP)

PriceLevel

Y1

P2

AD1

SRAS1

LRAS

AD2P1

Yf

e1

e2

SRAS2

LRAS

P3

e1

e2

e3

Direct monetary transmission 8

Money

MonetaryPolicy:

Base moneyInterest rate

Final Objective:

PricesOutput

Interest rate channel

Real interest

Cost of capital

Substitution effect

Income effect

Asset price channel

Exchange rateNet 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

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.

Player in the money supply process:• Central bank (Bank Indonesia)

• Banks (depository institutions)

• Depositors (individuals and institutions)

Money Suppy Process

Banking System Bank Indonesia’s Balance Sheet

Assets Liabilities Assets Liabilities

Reserves Deposits Government Securities

Currency in circulation

Government securities

Borrowings Banks’ giro/ reserves

SBIs SBIs

Shifts from Deposits into Currency

Nonbank Public Banking System

Assets Liabilities Assets Liabilities

Checkable deposits

- 100 Reserves - 100 Checkable deposits

- 100

Currency + 100

Bank Indonesia

Assets Liabilities

Currency in circulation

+ 100

Reserves -100

Net effect on monetary liabilities is zero

Deposit Creation: Single Bank

Excess reserves increase

Bank loans out the excess reserves

Creates a checking account

Borrower makes purchases

The money supply has increased

Bank BCA Bank BCA

Assets Liabilities Assets Liabilities

Securities -100 Securities -100 Checkable deposits

+100

Reserves +100 Reserves +100

Loans +100

Bank BCA

Assets Liabilities

Securities -100

Loans +100

Deposit Creation: The Banking System

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves 100 Checkable deposits

100 Reserves 10 Checkable deposits

+100

Loans +90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +90 Checkable deposits

+90 Reserves +9 Checkable deposits

+90

Loans +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 0.00

A 100.00 90.00 10.00

B 90.00 81.00 9.00

C 81.00 72.90 8.10

D 72.90 65.61 7.29

E 65.61 59.05 6.56

F 59.05 53.14 5.91

Total for all banks 1000.00 1000.00 100.00

The Formula for Multiple Deposit Creation

Assuming banks do not hold excess reserves

Required Reserves ( ) = Total Reserves ( )

= Required Reserve Ratio ( ) times the total amount

of checkable deposits ( )

Substituting

=

Dividing both s

RR R

RR r

D

r D Rides by

1 =

Taking the change in both sides yields

1 =

r

D Rr

D Rr

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.

M m MB

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

c = {C / D} C = c D and

e = {ER / D} ER = e D

Substituting in the previous equation

MB (r D) (eD) (c D) (r e c)D

Divide both sides by the term in parentheses

D 1

r e cMB

M D C and C c D

M D (c D) (1 c)D

Substituting again

M 1 c

r e cMB

The money multiplier is then

m 1 c

r e c

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

Instruments Operational target

Intermediatetarget

Ultimate target

Framework of monetary policy in Indonesia

Operational target Strategic 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)

Inflation Targeting “A Framework, Not A Rule”

Monetary operations

Policyresponse

Policy Indicators

Ultimate target

Inflationtarget

• Public welfare• Trade off between

inflation & output Inflasi dan Output

• Expectation

Output growth

Inflationforecast

BI RateMonetary

instruments

• Factors affecting inflation

• Linkage among macroecon variables

• Monetary trasmission moneter

PolicyCredibility

• 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

Transmission mechanism of monetary operations

Indicators :- M1, M2- Bank’s Loan

Indicators :- Import Price IndexIndicative Targets:

- Bank reservesIndicators:- Surveys- Leadings- Output Gap

Indicators :- CPI- Underlying Core- Asset Price- Other Price•Adm/Non•Trade/Non•Food/Non

OMO

DiscountWindow

RR

FXIntervention

SBIAuction

FASBI

Money Market

Liquidity

InterestRate

AssetPrice

Expectation &Confidence

ExchangeRate

DomesticSupply

DomesticDemand

DomesticInflation

Pressures

Indicators:- Money Market Rates- Deposit Rates- Lending Rates- IHSG- Exchange Rates

ForeignInflation

Pressures

Moral Suasion

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

DomesticInflationary

pressure

Inflation

Importprices

Monetary operations

How open market operations change monetary conditions?

Buying securities

Mo

Mo

Securities auction

Selling securities

i

M1 & M2

i

M1 & M2

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

Operational mechanism

OMOOMO

OMO RegulerOMO Reguler

OMO Non Reguler/Fine Tune Operation

OMO Non Reguler/Fine Tune Operation

SBI auctionSBI auction

FASBI/SWBIFASBI/SWBI

Reverse Repo SUN*)Reverse Repo SUN*)

SBI/SUN RepoSBI/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)

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

7 days 14 days

o/n o/n – 14 days

< 3 month -

Units

Rp 1.000 mio

Rp 1.000 mio

Rp 500 mio

Max. 25% o/s SBI bank

Rp 1.000 mio

Rp 1.000 mio

Rp 1.000 mio

Increment

Rp 100 mio

Rp 100 mio

Rp 50 mio

Rp 100 mio Rp 100 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 Bank, broker

Bank, broker

*)

Open market operations

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

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

Open market operations

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.

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)

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

Neraca Sistem Moneter

Aktiva Pasiva

1. Aktiva Luar Negeri Bersih Uang Beredar (M2)/ Likuiditas Perekonomian

2. Tagihan Bersih pada Pemerintah Pusat 1. M1

3. Tagihan pada Lembaga - Uang Kartal

dan Perusahaan Pemerintah - Uang Giral

4. Tagihan pada Perusahaan 2. Uang Kuasi

dan Perorangan

5. Lainnya Bersih

Keterangan: format standar penyusunan neraca analitis ini adalah seperti yang dipublikasikan

kepada masyarakat dalam Statistik Ekonomi dan Keuangan Indonesia

Neraca Otoritas Moneter

Aktiva Pasiva

Aktiva Luar Negeri Bersih Uang kartal

Aktiva Dalam Negeri Bersih - di m asyarakat (uang kartal )

- Tagihan bersih pada pem erintah pusat - di bank um um - Tagihan pada sektor swasta dom estik Saldo giro (cadangan bank)

- Tagihan pada bank um um - m ilik bank um um

Aktiva Lainnya Bersih - m ilik m asyarakat

------------------------- Uang Prim er (M 0)