i

OCCASIONAL PAPER

CASE STUDY: THE LINKAGES BETWEEN MONETARY AND FINANCIAL

STABILITY

Solikin M. Juhro

Tarsidin

Alexander Lubis

OP/1/2014

2014

Kesimpulan, pendapat, dan pandangan yang disampaikan oleh penulis dalam paper ini merupakan kesimpulan, pendapat, dan pandangan penulis dan

bukan merupakan kesimpulan, pendapat, dan pandangan resmi Bank Indonesia.

1

CASE STUDY: THE LINKAGES BETWEEN MONETARY AND FINANCIAL

STABILITY

Solikin M. Juhro, Tarsidin and Alexander Lubis

Abstract

The aim of this case study is to examine the existence of linkages between monetary

and financial stability, including: the interaction among macro variables (real sector, monetary

sector and financial sector) and between two different policy objectives (e.g. monetary stability

and financial stability); and the source of pressures (shocks) and its implication on the linkage

between monetary and financial stability.

Further-more, the study also analyze the policy strategy in mitigating the risks of

macroeconomic imbalances amidst high global economic uncertainties, e.g. during episodes

of capital inflows and outflows and understand the integration between monetary and financial

system stability frameworks and its possible implication on the change in central bank

mandate.

Keywords : Monetary policy, interest rates.

JEL Classification : E52, E43, E49

2

I. INTRODUCTION

1.1. CASE GUIDE

Learning Objectives

(i) To examine the existence of linkages between monetary and financial stability,

including:

- the interaction among macro variables (real sector, monetary sector and

financial sector) and between two different policy objectives (e.g. monetary

stability and financial stability);

- the source of pressures (shocks) and its implication on the linkage between

monetary and financial stability;

(ii) To analyze the policy strategy in mitigating the risks of macroeconomic imbalances

amidst high global economic uncertainties, e.g. during episodes of capital inflows

and outflows;

(iii) To understand the integration between monetary and financial system stability

frameworks and its possible implication on the change in central bank mandate.

Key Issues

- The nexus between monetary and financial stability; whether they are complements

or substitutes.

- Source of pressures affecting the linkage between monetary and financial stability,

as well as the work of monetary policy transmission mechanism

- Policy strategy to align the achievement of monetary and financial system stability

objectives (e.g. policy mix)

Case Description

- The case is about the examination of some policy perspectives on the linkages

between monetary and financial stability, including its dynamic interaction, source of

pressures, policy strategy, and institutional implication.

- Participants are requested to explore feasibility to implement some policy

instruments to mitigate the risks of macroeconomic imbalances, using the standard

macroeconomic model which is operated using MS Excel.

- Participants will be given advanced readings, content/scope/structure of the case

study, and leverage to accomplish the case exercises within the allowed time.

3

- Policy exercises and discussion on the answers given by participants during

presentations.

Policy Issues

There are several literatures that participants must read before examining the

case. Should the time allocated for the case study session rather limited, participants are

suggested to read an article exploring related policy issues on the linkages between

monetary and financial stability written by Solikin M. Juhro (2014), “The Linkages

between Monetary and Financial Stability: Some Policy Perspectives”, Bank

Indonesia Occasional Paper, March.

1.2. CASE STUDY

Identification of the Case

Case study is the combination of factual and fictional studies

(i) Factual experience of a case of Indonesian economy: economic developments,

challenges, and policy responses

Timeline: 2000 – 2012

(ii) Factual and fictional narration of some macroeconomic challenges (external

shocks), possible policy responses, and possible economic outcomes;

Timeline: 2013

(iii) Associated with point (ii), there are two conditions encountered as the impact of

external shocks (in this case the dynamics of capital flows).

First, normal condition (without feedback loops), a condition with a normal surge of

capital inflows, which is in accordance with the latest trends. In this condition, it is

assumed that there is no change in the risk perception/behavior in the financial

markets.

Second, abnormal condition (with feedback loop), a condition with a fairly massive

and (tend to be) persistent capital inflows, which could potentially disrupt

macroeconomic balance. In this condition, it is assumed that the risk perception in

financial markets changed (worsened).

(iv) There are two scenarios, namely baseline scenario and scenario with policy

options.

(v) Under scenario with policy options, several feasible policy instruments can be

utilized under policy mix strategy include:

(a) interest rate policy,

4

(b) foreign exchange intervention,

(c) change in Reserve Requirement ratio (RR), and

(d) change in Loan to Value ratio (LTV).

These instruments can be used partially (one instrument) or jointly (combination of

several instruments)

(vi) Possible shocks include:

(a) declining world economic growth,

(b) decreasing global interest rate, and

(c) change in domestic macro variables.

Supporting Evidence:

(i) Country Economic Profiles

Indonesian economic profile and challenges amid high global economic

uncertainties: maintaining internal and external balances.

(ii) Chart Packs of Indonesian Economy

5

II. POLICY ISSUES

1. Preview on Monetary Stability and Financial Stability Nexus

Given the definitions of monetary stability and financial stability, there is a question

regarding their nexus: are the two mutually supportive (complementary) or do they work

against each other (substitute) in a sense of trade-off?1 The conventional view is that monetary

stability supports financial stability. Even so, the main proponents of this view regard monetary

or price stability as more of a ‘sufficient condition’ for financial stability (Schwartz, 1995). This

view assumes that inflation is one of the main factors behind financial market instability. A

related opinion is that inflation increases the likelihood of misperceptions concerning future

income achievement and exacerbates the problem of asymmetric information between lenders

and borrowers. In another view, high inflation also encourages high price fluctuations, which

create business uncertainty and even banking crisis.

This argument is consistent with the reverse relationship, in which a banking crisis will

trigger monetary instability. In this respect, a twin crisis involving the banking system and the

exchange rate will cause unexpected or even reversed monetary policy impact (Goldfajn and

Gupta, 2002). In a crisis involving only the exchange rate, a tight monetary policy has the

potential to stabilise the exchange rate, a reversal through changes in the nominal exchange

rate, and financial sector. However, in a banking crisis, the opposite will take place, whereby

a tight monetary policy will reduce the probability of the reversal. In this situation, the monetary

policy response will be influenced by several factors, such as the extent of the currency

mismatch at domestic banks and the discretionary powers of the central bank in supplying

liquidity in a crisis situation.2 The difference in the nature of relationship during different crises

is in accordance to the conventional view that there is generally no trade-off between monetary

stability and financial stability.

The ‘new environment’ hypothesis, however, suggests such a trade-off. This is based

on the proposition that successful inflation control by the central bank can foster overly

optimistic market perceptions and forecasts for the future of the economy. Incorrect

1 The broadly accepted definition of monetary stability in academic circles and for the central bank is a condition that

guarantees the attainment of price stability as defined by low, stable prices (subdued inflation). The factual basis for this lies

in the important role that price changes play in the process of adjustments and decision-making by economic agents.1 However,

a clear understanding of financial stability is missing because of the absence of agreement on a definition. In this respect,

Miskhin (1991) defines financial stability as a condition in which the financial sector guarantees efficient allocation of savings

and investment in a sustainable manner and without significant disruption, but this definition is considered too broad. A more

easily discernible definition is used in analysis, in which financial stability is a situation marked by stable asset prices and the

absence of banking crisis, with market interest forces transmitted readily into interest rates (Issing, 2003). In this paper,

financial stability is understood more in line with the latter definition.

2 As happened in Indonesia, the complexity of problems during the twin crises in 1997/98 undermined the effectiveness of

monetary policy responses. This was reflected not only in high interest rates, but also massive liquidity flows.

6

perceptions create a false sense of security and lead to miscalculation of asset values with

possible future negative impact. Borio et al. (2001) indicates that the combination of increased

asset prices, high economic growth and low inflation within the context of a stabilisation

programme can foster exaggerated expectations of future economic performance.

Overoptimistic expectations can lead to drastically escalating activity on the asset and credit

markets that surpasses the level of potential productivity improvement. This in turn drives up

asset prices and fuels a booming trend and inflationary pressure. At this stage there is little

empirical evidence to support such a proposition.

Issing (2003) analyses the trade-off by taking into account the time horizon to ascertain

whether trade-off is a short-term or long-term. In this respect, the trade-off possibly arises in a

short-term, during a period of sudden disinflation (inflation below the predicted rate). In the

‘new environment’, this could bring on fragility because of the effect in driving down nominal

interest rates, which further exacerbates moral hazard in the form of increased high-risk

lending in a low interest, low inflation environment. In some cases, in the very low inflationary

environment, this opens the possibility to an asset price bubble. However, the fragility in the

disinflation period will tend to be short-lived. Not only will the economy adjust itself to the low

inflationary environment, but the central bank is also likely to raise nominal interest rates to

curb inflation in asset prices caused by excessive investment and in so doing prevent long-

term inflationary pressure and any resultant economic crisis. Thus, within the context of the

forward-looking central bank mandate of building price stability with a view to the horizon

(medium and long-term), this conflict will disappear of its own accord.3

In following discussions, especially on the onset of global financial crisis of 2008/09,

Borio and Zhu (2008) put forward the existence of ‘risk-taking channel’ and suggest three

mechanisms to explain this new channel. The first relates to valuation factors, income and

cash flows. Under this mechanism a decline in interest rates will increase the evaluation

perception on asset price and profit potential. In this context, a decline in interest rates is

parallel to the perception of a rise in profit potential and cash flow. What emerges from this

behavior is a rise in risk-taking behavior by economic players when monetary policy stance is

loose. The second mechanism corresponds to the correlation between interest rates and the

target (nominal) rates of return. This mechanism is in line with the assumption that a decline

in interest rates will increase the money illusion towards asset ownership attributable to a

sticky rate of return. Similar to the first mechanism, this will subsequently encourage risk-taking

3 From another standpoint, because of the threat posed by financial instability to inflationary stability in the medium and long-

term, the price stability focus in central bank actions must take account of financial stability. The implication of possible short-

term conflict certainly does not overrule the conventional wisdom that price stability promotes financial stability.

7

behavior. The last mechanism relates to the positive effect of transparency from central banks.

In this respect, greater transparency or central bank commitment will reduce future uncertainty

and lower the risk premium, consequently improving risk-taking behavior.

Some empirical studies support the argument of a risk-taking channel in the monetary

policy transmission mechanism. Altunbas et al. (2009), for instance, find evidence that

unusually low interest rates over an extended period of time cause an increase in banks' risk

taking, although one should analyze further the issue related to what extent is monetary policy

or the general level of interest rates that is significant for the bank’s risk-taking. De Nicolò et

al. (2010) also suggest that monetary policy easing will increase risk taking, but this

relationship depends on the health of the banking system, i.e. less so for poorly capitalized

banks. These findings bear on the policy debate on how to integrate monetary and

macroprudential policy framework to meet the dual objectives of monetary stability (price) and

financial stability. This issue becomes particularly relevant in the future, given the fact that the

nexus between monetary and financial stability, whether they are substitutes or complements,

will depend on the types of shocks to the economy and the role of portfolio effects and risk

shifting that force the bank’s condition.

This paper explores background issues on the linkages between monetary and

financial stability from central banking policy perspectives. The following section presents

financial sector behavior and monetary policy effectiveness, mainly touching upon financial

sector characteristic that can potentially raise macroeconomic instability by developing output

fluctuation (procyclicality) and its implication on the works of monetary policy. The third section

elaborates the need to integrate monetary and financial system stability framework, including

the implementation of macroprudential policy in some countries. The fourth section provides

policy instrument mix as a key strategy to implement monetary and financial system stability

framework. It elaborates objectives and policy mix variations, as well as explores some

technical aspects of implementation. The last section derives conclusion and implication,

especially on the adjustment of central bank mandate and its consequences on policy

governance.

2. Financial Sector Behavior and Monetary Policy Effectiveness

The previous section poses the importance of the financial system for the monetary

policy transmission mechanism, implying the need for central bank to better understand the

linkage between the financial sector and the monetary policy. This issue has become

pronounced especially since the occurrence of the global financial crisis of 2008/09. The crisis

gives a key lesson that the financial sector plays an extremely crucial role in macroeconomic

8

stability because of its behavior which triggers excessive procyclicality.4 Due to its procyclical-

nature, financial sector can potentially raise macroeconomic instability by developing output

fluctuation. The procyclical characteristic of the financial sector is inherently attributable to a

number of factors. Firstly, asymmetric information in financial market which trigger financial

accelerator. With this kind of market characteristic, when the economy is in a period of

contraction and collateral values are low, even a good quality corporation with a profitable

project will find it difficult to get access to credit. On the contrary, when economic condition

improves and collateral values increase, the same corporation will regain its access to banks

and thus adds to economic stimulus. Although financial accelerator is the main mechanism

behind the occurrence of procyclicality, disproportional responses of market players in

perceiving risks also contributes to the worsening of procyclicality (Borio et al., 2001).

Procyclicality is not just the result of interactions between business cycle and financial

cycle; it is also affected by risk-taking cycle, which is a characteristic marked by over-optimism

during economic boom and over-pessimism in times of economic bust cycle (Nijathaworn,

2009). The interaction of the three can be typically described in the context of boom-bust cycle.

Initially, when the economy moves at an expansion phase characterized by macroeconomic

stability and escalating growth, investor confidence raises optimism when assessing the

economy. This will lead to the risk-taking behavior, which will eventually push up credit

demand and asset prices.

Table 1. Interaction between Business Cycle, Risk Behavior and Financial Cycle

Business Cycle Risk-Taking Cycle Financial Cycle

Expansion Phase

• Macroeconomic stability

• Increased economic growth

• Confidence and Optimism up

• Risk-taking up

• Credit demand up

• Risk value down, interests rate spread down

• Asset prices up, pushing up collateral value

• Leverage up

• Foreign capital inflows up

• Credit extension up

Contraction Phase

• Lifted macro volatility

• Decreased economic activity

• Market confidence down

• Risk averse

• Credit demand down

• Banks do deleveraging

• Loan loss provision up

• Interest rate spread up

• Credit extension down

• Capital inflows down

Source: Nijathaworn (2009), edited.

4 Procyclicality is defined as a character of financial sector which follows economic activity. Through the work of financial

accelerator, it further pushes an economy to grow faster when in a cycle of expansion and weaken during a period of

contraction.

9

In this optimistic period, the risk in financial sector goes down, lending rate spread

decreases, and risky asset allocation is reduced as banks prefer to apply a short-term

perspective to a longer-term one. Surging asset prices push collateral values up thereby

boosting credit expansion. This will further improve market confidence and encourage the risk

taking behavior as reflected in soaring leverage. The higher credit expansion drives

corporations to boost investment and households to raise their consumptions thereby further

lifting economic growth. On the contrary, when confidence toward the economy decreases,

investor behavior turns into risk aversion mode. As a result, asset prices go down, causing

collateral values to fall. Banks respond by deleveraging move, shifting their portfolio from high-

risk credit to low-risk asset, such as central bank certificate and government bond, in a bid to

maintain their capital adequacy. Reserve allocation is also lifted to anticipate worsening credit

quality. This condition slashes credit expansion which, in turn, will be deteriorating the

economy.

Secondly, procyclicality may also emerge in line with the characteristic of the regulation

in the financial sector which is inherently procyclical. For instance, the rule on capital and

provision determines a softer requirement to banks during a period of economic boom or

expansion phase. One of the rules in the banking sector which is deemed procyclical is Basel

II. Basel II is especially aimed at strengthening banks’ risk management. However, it also

poses a procyclical impact as Basel II Framework indirectly encourages banks not to

accumulate additional capital when banking and economic condition is prospective, and to

raise their capital when such condition deteriorates. Consequently, in the event of a crisis

banks are required to increase their capital ratio, but they are forced to seek funding in a

limited capacity. This may further worsen the banks’ condition. In addition, the Internal Rating

Based approach under Basel II demands that capital requirement be based on banks’

estimation on the possibility of default of their loans and related losses, as both of them tend

to increase during a crisis period. This may exacerbate the impact of crisis on credit supplies

and the whole economy.

Furthermore, accounting standards are suspected of contributing to the triggering of

procyclicality. Under accounting standards that assess banks’ balance sheet components on

the basis of market value approach, if the economic situation is improving, the value of the

assets or the performance of banks will also be considered improving so that banks do not

need to have high capital requirement and provision. In such a situation, banks are inclined to

make expansive moves. However, in the event of a crisis or during a contraction period, their

asset values would fall but they would not be able to use their capital or risk provisions

immediately to maintain their balance sheet condition. This will subsequently lead to the

worsening of their condition and potentially pose a systemic risk in the banking sector.

10

Empirically, procyclicality can be observed through the development of banking credit

during both expansion and contraction periods. Observable correlations between average

credit growth and economic growth indicate that the higher the economic growth is, the higher

the average credit growth would be. Moreover, credit was seen to grow faster than GDP during

an expansion period and grow slower during economic downturn. Table 2 shows procyclicality

from several Asian countries measured by correlation coefficient of GDP and real credit.

Table 2. Procyclicality of Real Credit and GDP in some Asian countries

Countries Correlation Coefficients

Indonesia 0.82

Malaysia 0.51

Phillipines 0.33

Thailand 0.32

Australia 0.26

Jepang 0.48

China 0.31

Hongkong SAR 0.30

Source: Craig, et al (2005).

The complexity of problems accompanied procyclicality behavior in financial sector

ultimately takes its toll on the works of monetary policy transmission mechanism. Mishkin

(2009) says that monetary policies potentially tend to be more efficient during economic crises

rather than during normal times, thereby providing a base to carry out macroeconomic risk

management to deal with problems related to economic contraction in times of crisis. This

statement tells that there is a link between monetary stability and financial sector stability.5

Some empirical observations support the facts on the close correlations between financial

sector behavior and monetary policy transmission mechanism. Nier and Zicchino (2008)

discover that banking credit supply is affected by monetary policy stance which interacted with

balance sheet stress and then transmitted through bank’s losses. It concludes that the

repercussions of the interaction between monetary policy stance and the bank’s losses grow

stronger during a crisis period, with an assumption that financial sector risk magnitude will

grow higher in case of economic crisis.

Figure 1 describes the work of transmission mechanism in the presence of risk

perception (risk taking). In an event when the economy moves at an expansion phase

characterized by macroeconomic stability and escalating growth, investor confidence raises

5 As mentioned in the early part of this section, Borio and Zhou (2008) explain the importance of risk taking channel within

monetary policy transmission mechanism. Risk taking channel, in contrast to the financial accelerator concept disclosed by

Bernanke and Gertler (1999), affects banking credit supply through banks’ decision to extend credit in accordance with banks’

behavior changes against credit risks. In connection with this, empirical studies have provided sufficient evidence over the

existence of risk taking channel within monetary policy transmission mechanism.

11

optimism when assessing the economy. This risk-taking behavior, which firstly triggered by

monetary policy, will eventually push up credit demand and asset prices. Changes in financial

sector as reflected in adjustments of financial variables (financial stability) influence aggregate

outcomes such as economic growth and employment, which are directly linked to monetary

stability. This is where a linkage between financial stability and monetary stability occurs. A

healthy macroeconomic environment and monetary stability has bidirectional feedback with

financial system stability. Any developments between monetary and financial stability will be

considered by monetary policy makers through macro-prudential policy feedback rule, which

are scrutinized under financial stability framework.

Figure 1. Monetary-Financial Stability Linkage and Monetary Transmission

Mechanism

Within this policy perspective, in order to strengthen the framework of monetary and

financial system stability, central bank is demanded to be more flexible and creative in

responding to emerging uncertainties within the economy and to think beyond public

perception. Such a flexibility is not only linked to the adjustment preference to control inflation

and manage macroeconomy on the one hand, and to put the role of financial system stability

on the other hand, but it is also crucial to overcome the conflict potential or “trade-off” between

targeting monetary stability and financial system stability itself.

3. The Integration of Monetary and Financial System Stability Framework

Financial System:

Intermediation

Resiliency

Efficiency

Interest Rates

Exchange Rate

Credit (Lending)

Balance Sheet

Asset Prices

Money Monetary Policy

Strategy, Response,

Instruments

Expectations

(e.g. inflation,

financial condition)

Aggregate Demand

Savings/Investment

Aggregate Supply

Employment

Wage & Price Setting

Other Aggregate

Outcomes:

Economic Growth,

Employment

Monetary Stability

Monetary policy feedback rule

Financial Stability Framework

Micro-prudential

Policy

Macro-prudential

Policy

Risk Perception

(Risk Taking) Financial Stability

Macro-prudential policy

feedback rule

Policy mix

Linkage

12

Empirical facts show that the macroeconomic stability achievements in the period of

great moderation between 1987 until 2007 would not automatically isolate global economy

from the impact of crisis which was generated by the susceptibility of financial sector.

Therefore, the central bank’s policy formulation should evaluate the strategic role of monetary

policy and financial system at the same time. The dynamics during financial crisis has showed

that monetary policy need to be further directed to anticipate macroeconomic instability risk

stemmed from financial system. This lead to an implication that shows a healthy

macroeconomic management should also consider financial system stability as the foundation

to realize a sustainable macroeconomic environment. “There is no macroeconomic stability

without financial stability”.

Within this policy perspective, in order to strengthen the framework of monetary and

financial system stability, central bank is demanded to be more flexible and creative in

responding to emerging uncertainties within the economy and to think beyond public

perception. Such a flexibility is not only linked to the adjustment preference to control inflation

and manage macroeconomy on the one hand, and to put the role of financial system stability

on the other hand, but it is also crucial to overcome the conflict potential or “trade-off” between

targeting monetary stability and financial system stability itself.6 In this connection, the

flexibility in policy implementation can be done through, among others, additional instruments

(in this case macroprudential instruments) in addition to establishing a longer time horizon to

reach inflation target in order to accommodate output stabilization in a short term period. In

connection with the measures to overcome the potential of policy conflict, it is no less important

to prioritize the policy goal, for example by setting a price stability achievement as the main

policy goal.

The urgency to strengthen monetary and financial system stability framework requires

a strong financial infrastructure along with adequate examination and supervision function to

support the integration of domestic market into a financial system with a growing complexity.

In relation with this, Borio (2003) emphasizes the need to strengthen regulatory framework or

macroprudential policy thereby enabling to limit the risk when financial market comes under

heavy pressure for a long period of time, which may force real output within the economy to

tumble.

6 The occurrence of trade-off between reaching stability in monetary and financial system depends on the types of the shocks

(Geraats, 2010). If the shocks come from demand side, then the efforts to stabilize price and financial system will generally

move in a simultaneous way. Central banks may adjust the interest rate to cope with the shocks in aggregate demand side in a

bid to stabilize not only output gap, but also prices of goods and assets. Meanwhile, shocks stemmed from supply side tend to

have a reversal effect against price and financial system stability. For instance, this happens when shocks in supply side move

positively by suppressing inflation but lifting output. In such a condition, an expansive monetary policy will likely incite asset

prices bubbles.

13

Conceptually, macroprudential policy is a prudential regulation instrument aiming at

enforcing financial system stability as a whole, instead of the individual wellbeing of financial

institutions. Analogically, microprudential policy is a prudential regulation instrument intended

to maintain the individual health of financial institutions. “Macroprudential policy seeks to

develop, oversee, and deliver appropriate policy response to the financial system as a whole.

It aims to enhance the resilience of the financial system and to dampen systemic risks that

spread through the financial system” (The G-30). Therefore, macroprudential policy is used to

prevent boom-bust cycle of credit supply and liquidity from happening, which may lead to

economic instability. With its role in maintaining the stability of financial intermediation supply,

a macroprudential policy plays a role in backing monetary policy goal to maintain price and

output stability.7

In a latter development, in line with the change in financial sector arrangement,

especially in the post 2008/09 crisis period, many central banks have applied macroprudential

policy instruments in a wider scope. In this connection, several instruments previously better

known as microprudential instruments (such as loan-loss provisioning requirements, or loan-

to-value) or monetary instruments (such as reserve requirements) were also used to prevent

systemic risk and to maintain financial system stability in economic activity cycle. Such policy

instruments were not focused on the efforts to deal with the risk within individual bank.

Therefore, these policy instruments can be categorized as policy instruments in a wider

macroprudential perspective. Some macroprudential policy instruments used in several

countries can be seen in Table 3.

Table 3. Implementation of Macroprudential Policy in some Countries

Problems Instrument Countries

Leverage (procyclicality potential)

Risk weighted adjustment in capital regulation

India, Indonesia, Malaysia, Estonia, Ireland, Portugal, Norway

Application of capital to risk-weighted asset ratio

India, Bulgaria, Croatia, Estonia, Australia

Credit Application of countercyclical provisioning (provision for certain credit)

China, India

7 There are two important dimensions of macroprudential policy. Firstly, cross-section dimension, which shifts the focus of

prudential regulation applied on financial institution individually to regulation system as a whole. The history of financial

crisis tells that most of the financial crises occurring in the world were not caused by individual bank’s trouble and then

infected to the system as a whole. On the contrary, major crises in the past were caused by exposure to macro-financial

instability which was conducted simultaneously by most of actors within the financial system. Therefore, a more holistic view

on financial system and its correlation with macroeconomy through various sides is urgently needed. The second dimension

is the time-series one, namely macroprudential policy which aims to restrain the risk of excessive procyclicality within the

financial system. In this context, macroprudential policy should be specially designed to make it capable of eliminating, or at

least mitigating procyclicality. Principally, it is about how to encourage financial system to prepare a sufficient buffer when

economic conditions improve, or when the instability in financial system generally occurs, and how to use this buffer during

economic slump.

14

Problems Instrument Countries

(Correlation and characteristics of borrowers, pressure over macro stability)

Limitation of loan to value ratio on certain sectors (with potential bubble)

China, Hong Kong, Korea, Singapore, Malaysia, Thailand, Bulgaria, Norway, Portugal, Rumania

Credit limitation to certain sectors (such as property, credit card)

Korea, Malaysia, Philippines, Singapore, Thailand, Rumania

Change in reserve requirement across the board or with certain target

China, India, Indonesia, Korea, Malaysia, Finland, Estonia

Liquidity (risk potential on certain aspects)

Buffer application to minimize reliance on risky funding sources

India, Korea, Philippines, Singapore

Application of loan to deposit ratio China, Korea, Indonesia

Source: Borio and Shim (2007), Hannoun (2010), G-30 (2010)

Strengthening monetary and financial system stability framework requires a right

monetary and macroprudential policy integration. As it has been known, the main goal of

monetary policy is to maintain price stability. To reach this goal, central banks traditionally use

interest rate as their main instrument. However, keeping price stability is still not sufficient to

guarantee a macroeconomy stability achievement, as financial system with its procyclical

behavior triggers excessive economic fluctuation. Meanwhile, the goal of macroprudential

policy is to guarantee the financial system resilience as a whole in a bid to support financial

intermediation service for the economy as a whole. With its countercyclical role,

macroprudential policy contributes to supporting the goal of monetary policy in keeping price

and output stability.

The objectives achieved through monetary and macroprudential policies should

reinforce each other. Steps to empower financial system resilience will also improve monetary

policy, including the protection of the economy from sharp fluctuations within financial system.

On the other hand, macroeconomy stability will lessen the vulnerability of financial system with

its procyclical characteristics. Therefore, overall, interest rate may not need to move in a

magnitude usually needed in times of no policy integration or coordination. Meanwhile,

macroprudential policy affects credit supply condition, consequently monetary policy

transmission. The effectiveness of this policy coordination definitely relies on macroeconomic

environment, financial condition, intermediation process, and the level of capital and asset in

the banking system. Hence, it is not realistic to expect the combination of monetary and

macroprudential policy to be fully capable of eliminating economic cycles. The main goal of

this policy integration is to moderate cycles and bolsters financial system resilience in a macro

scale.

The improvement of monetary and financial system stability framework, through

monetary and macroprudential policy integration, can be depicted in the following figure.

15

Figure 2. Integration of Monetary-Macroprudential Policy

This monetary and macroprudential policy can be described as follow. For instance,

macroprudential policy aims at tightening capital and liquidity requirement during economic

upswing, thus driving banks to cut its credit growth in an effort to build up banks’ resilience to

anticipate a future economic slump. In this condition, the efforts to keep up banking sector’s

resilience will simultaneously back up monetary policy goal to stabilize credit supply.

Therefore, the objective of this macroprudential policy with its countercyclical characteristic

will synergize with the goal of the monetary policy in reducing excessive economic fluctuations.

Figure 3. Monetary and Macroprudential Policy in Dampening Procyclicality

There are some conditions required to make the integration of monetary and

macroprudential policy run well. Firstly, there is a need to understand about the framework of

the linkages among monetary policy, macroprudential and microprudential policies. This is to

take into account the conflict potential to reach the objective of the policy. That is why the use

of instrument mix or adding new instruments can be considered as the right alternative move.

Secondly, there is a need to understand about the work of monetary and macroprudential

Monetary Stability

Monetary Policy

(price stability)

Interest Rate

Reserve Requirement

(RR)

The Soundness of

Individual Bank /

Financial Institution

Microprudensial Policy:

Bank regulation and super-

vision (individual bank/

financial institution risks)

Regulations on

capital and liquidity

Financial System Stability

Macroprudential Policy

(systemic risks)

Loan to Value (LTV)

Reserve Requirement (RR)

Countercyclical Capital

Buffer (CAR)

Upswing

Downswing

Monetary Policy

Macroprudential Policy

Desired economic cycle

16

policy transmission in affecting economic activity. This requires a more integrated analytical

framework, especially when evaluating the important role of financial sector. Thirdly, there is

a need to measure the right risk behavior indicator in supporting the risk system monitoring.

By measuring the risk indicator in addition to supporting the right monitoring system, it will also

strengthen the analysis on the work of transmission mechanism through risk taking channel.

4. Policy Instrument Mix as A Key Strategy

The Objectives

In an ideal financial market, central bank normally relies on a single instrument to reach

monetary policy goal. However, in reality, market imperfection always happens, such as

matters related with banking structure and soundness, distribution gap in market liquidity, and

excessive market fluctuation. This imperfection forces the preference to employ instrument

mix and wider operational procedure to support the effectiveness and efficiency of monetary

policy implementation.

Empirically, the variation in employing instrument mix is based on several

considerations as follows (Baliño and Zamalloa, 1997). Firstly, to secure the achievement of

monetary management in weathering the turbulence distorting the supply and demand of

banking reserves. Secondly, to adapt to instrument and operational procedures in line with

institutional constraints affecting the work of an instrument. Thirdly, to gain the objectives of

other policies deemed crucial and supportive to the work of monetary policy transmission

mechanism. Fourthly, to adjust to macroeconomic policy environment, especially to the type

of monetary and exchange rate regime. Referring to Timbergen rule, it is said that an

instrument should not be used to target more than one objective, therefore the application of

instrument mix is deemed substantial in case of a change in economic condition along with its

challenge also contributes to supporting the policy objective enlargement targeted by policy

makers.

In this connection, beside the availability of several policy instruments, the most

significant thing is on how to make the effort to mix or to coordinate the application of the

instruments able to raise policy effectiveness in supporting the economic development in

general. This is to consider that each instrument has its own unique timing and magnitude

characteristic. In a latter development, the application of instrument mix has become a

trending practice in a lot of central banks. In this regard, the type of the mix is not only limited

to monetary policy instruments, but it also tends to include the mixture between monetary

policy instruments and other policy instruments, such as those of macroprudential policy. With

a different policy umbrella, it is not easy to formulate a right kind of mix.

17

Policy Mix Variations

As previously mentioned, the complexity of problems generated by the 2008/09 global

financial crisis has increased consciousness that the role of financial system should be taken

into account in monetary policy formulation. For instance, decision has to be made as to

whether or not a monetary policy is needed to respond to asset price developments which

potentially lead to imbalances in the financial market. Apart from the growing arguments over

such an issue, even though monetary policy is crucial in controlling financial sector

imbalances, this does not mean that asset price stability, for instance, should be an explicit

target of the monetary policy. This is to consider that the monetary policy itself is not capable

of controlling asset price, especially when asset price speculations contribute to surging asset

prices, which makes return on assets become extremely high. In such condition, any changes

in interest rate will not affect investors’ portfolio, especially against those investments within

the financial market. An across-the-board interest rate hike will ‘overkill’ the economy as a

whole.

Therefore, monetary policy needs additional instruments to support it in controlling the

surge in asset price within the financial market. In this case, macroprudential policy

instruments which are designed to do countercyclical action can be utilized to overcome

procyclicality and back up monetary policy in order to reach macroeconomy stability. One of

the examples of macroprudential instruments which are applicable in complementing interest

rate in managing asset price development is Loan-to-Value (LTV), namely the ratio of money

borrowed on a property to the property’s fair market value, which is substantially aimed at

fending off asset bubble in housing sector. In this connection, LTV is set on a certain limit (for

instance at the maximum of 80%) which is generally considered as a norm or a reference in

credit expansion for real estate development, which is safe enough in accordance with

macroprudential point of view.

Instrument mix is also applicable in quelling the complexity of the problems

accompanied by the slowdown in the economic recovery of advanced countries, which propels

rapid foreign capital inflow into emerging countries. In certain countries, such as China, India,

and Indonesia, the foreign capital inflow phenomenon complicates the efforts to oversee

domestic financial market’s soaring liquidity. A higher excess liquidity will potentially propel

the acceleration of credit growth and inflationary pressure on the monetary side. Under this

complexity, in the form of distortion on both external and internal imbalances, the role of

interest rate instrument turns to be extremely limited.

Interest rate hike as a measure to control economic liquidity done by central bank will

eventually be offset by a significant force driven by foreign capital inflow, which turns the efforts

to oversee macroeconomic stability to be ineffective. This offsetting phenomenon repeats itself

18

as a vicious circle of capital inflows. In such a condition, monetary policy transmission taken

through interest rate channel will face constraints, especially over the work of the term

structure interest rate hypotheses. In this case, the development of monetary aggregates,

including credit, tends to be inelastic to interest rate development. For that reason, if interest

rate is used as a monetary instrument, the complexity of the problems requires the use of

other instruments (non-interest rate) as a backup to optimally reach the goal of monetary

policy.

In connection with this, there are some examples of instrument mix applicable to

supporting the role of interest rate, for instance reserve requirement (RR). The modification of

RR in domestic exchange is often seen as a part of those instruments to implement monetary

and exchange rate policy. Evaluating the phenomenon on how developing countries

responded to rapid inflows of foreign capital, the attention has been focused more on the use

of RR to moderate financial cycle. The changes in RR can be used to supplement or to replace

the use of interest rate instrument to control the credit’s impact in the economy. In a latter

development, a number of countries have also applied RR on their foreign exchange based

financing provided by financial institutions. In this case, macroprudential issues are closely

related with currency mismatch and vulnerability of foreign exchange liquidity within banking

system, which may also be caused by the financing scheme itself. Additionally, RR variation

has been applied based on a certain consideration. In general, the application of RR variation

is for macroprudential purposes in a condition where the credit market is segmented and

dominated by intermediation institutions, which is tightly regulated. Although the same impact

may be generated from the application of interest rate instrument, the use of RR can be

classified as a more direct way to influence banks’ funding cost and capacity in triggering

financial market imbalances.

The forms of instrument policy mix applied by a lot of central banks are also varied.

One of them is through reliance on foreign exchange market intervention, which is generally

connected with foreign exchange reserves accumulation in a bid to manage an external

balance. In a flexible exchange rate system, central banks intervene foreign exchange market

to dampen exchange rate volatility, and/or to accumulate foreign exchange reserves. This can

be seen on the fast growing foreign exchange reserves over the latest decade. Yet, foreign

exchange reserve accumulation bears its own cost. In one hand, foreign exchange reserves

can be seen as a kind of macroprudential instrument in enhancing resilience during an episode

of financial market pressure. On the other hand, persistently large foreign capital inflows along

with a surge in central bank’s foreign asset almost always enlarge banking system balance.

This will eventually lead to credit and price asset booming and then end up with a crisis.

19

The use of macroprudential instrument thus raises a question over how this instrument

connects with interest rate policy; whether as a complement or a substitute. As understood,

the use of both instruments is a tactical way to influence financial sector condition.

Macroprudential instruments do its work by affecting the financial sector incentives and

resilience and directly act upon monetary policy transmission mechanism. Such instruments

work by either strengthening or weakening policy repercussions which will ultimately be

reflected on the accessibility and the cost of borrowings faced by debtors (private and public).

From this point of view, such macroprudential instruments fall into a category of a complement.

For instance, in weathering high inflationary pressure, fast growing credit and soaring asset

price, central banks intend to tighten monetary policy and employ additional instruments with

a countercyclical role. In this case, both of policy interest rate and macroprudential policy will

strengthen each other to tighten financial sector condition.

However, as both of them will eventually affect the accessibility and cost of borrowings,

they could also be classified as a substitute. Specially, it can be seen that interest rate and

macroprudential instruments may be adjusted to tackle shocks in macro economy and

financial sector at the same time. For instance, central banks can either raise interest rate or

RR. The level of interest rate magnitude and the RR ratio to be set will depend on the

consideration of how close the position of the macroeconomy and financial stability is, and the

relative effectiveness of the use of such instruments. For example, a dilemma emerges when

inflationary pressure is low, while credit and asset price grow fast. One of the possible

scenarios of using instrument mix is through the use of interest rate policy to fight inflation,

while the RR policy is employed to confront financial system stability risks. Based on such

interpretation, interest rate may not change due to a low inflationary pressure, while RR may

be raised to smother fast credit growth and the potential of asset price hike. The advantage

which may be taken through this measure is that the increase in RR may not attract capital

inflow significantly, unlike the impact of interest rate hike. However, whether the application of

this scenario is optimum enough, it needs to be further analyzed.

Technical Aspect of Implementation

When implementing the policy instrument mix, there are several aspects that need to

be considered to make them work optimally, these include: (i) signals necessary to be

responded, (ii) response characteristic, (iii) timing of implementation and procyclicality, (iv)

effectiveness and calibration of policy measures, (v) policy communication.8

8 For further discussion on such issues, see Moreno (2011), Committee on the Global Financial System - BIS (2010), Barell et

al. (2010) and Born et al. (2010).

20

(i) Signals necessary to be responded

Within the forward looking policy perspective, policy response should be directed to

anticipate signals related to distortion on future macroeconomic balance. In this case, policy

response may not be necessary in case of temporary shocks. The lessons from the past crises

show that a number of indicators and analysis can be used as guidance for policy response

through their advantage to detect resilience, imbalances and systemic risks. Some of the

examples of such indicators include financial system resilience indicator, macroeconomic

resilience indicator, and systemic risk indicator. Generally, those indicators are substantially

set within an early warning system framework.

Therefore, the accuracy of policy response will highly depends on the performance of

those indicators in predicting the possibility of imbalances. Although theoretically such

indicators may be easily constructed, the performance of empirical model and analysis in

predicting imbalances, or through early warning system framework, is still not convincing

enough. For instance, it is difficult to notice the exact timing of credit growth level which can

be sensitive to economic vulnerability, bearing in mind that fast credit growth is also needed

within the fast changing economy due to profit-taking chances which lead to financial

deepening, as experienced by various Latin America countries. Thereby, there is urgency to

have a more systematic research and better understanding over systemic risk characteristics

and their correlations to the benefits rose in macroeconomic perspective.

(ii) Response characteristic

In formulating response of macroprudential policy, one of the crucial issues is whether

the response will apply a rule or discretion (rule vs. discretion). Like in the monetary policy,

the trade-off between a rule versus discretion always happens. A rule provides a certainty for

market players and credibility to central banks. However, a rule which is too rigid undermines

the flexibility to respond to both structural changes and uncertainties often occurring in the

financial market.

On the other hand, a discretion provides room for central banks to assess the

macroprudential impact against financial system and the economy and then to apply some

adjustments toward the use of such approaches in addition to setting a judgment over the

possibility of future policies to be taken. Discretion definitely triggers uncertainties over

possible policies to be taken in the future. These uncertainties will drive market players to be

highly prudential by maintaining liquidity and capital ratio in a higher than required level.

Consequently, banks become less efficient and charge the cost of the capital to borrowers,

creating a high cost of credit in the economy. Discretion may also lead to forbearance,

especially when confronted with a difficult or unpopular decision to be taken. Even so, such a

21

discretion policy bears a legal consequence to central bank. Considering the strengths and

weaknesses of both rule and discretion, the model of decision can be made through a rule-

constrained discretion.

(iii) Timing of implementation and procyclicality

It is important to take into account the timing of the application of a policy during an

economic cycle. This is partly because a macroprudential regulation is often procyclical.9 A

number of other issues pertaining to the application of macroprudential framework are

countercyclical as they are.

- Firstly, related to how much weight is given to measures to stabilize an economic cycle

(e.g. GDP) as compared to measures to manage the cycle of the financial sector (e.g.

credit and asset prices). One fundamental issue is whether with the rapid innovation in the

financial sector, the policy-making authorities are able, in a timely fashion, to conduct

extraction on the cycles of the financial sector (e.g. “excessive” credit growth, “inflated”

asset price, “abundant” liquidity) from the variations of the normal cycle and long-term

trends.

- Secondly, related to who should assess the cycle (the public sector or the private sector)?

As is known, economic cycles are unobservable, and methods to estimate them are fraught

with many uncertainties. Therefore, a diversity of opinions is likely to occur. One of the

solutions for policy-making authorities is by relying on a group of independent experts like

the approach they use in Chile (to determine the long-term trend of the country’s GDP and

copper prices) in implementing the fiscal rule.

- Thirdly, related to the timeliness of action taken. Lateness in taking action may have

implications on actions that are more procyclical than countercyclical.

- Fourthly, related to whether the prudential ratio should remain constant or move with the

cycle. A solution would be to set a wide enough range of stability for, say, the targeted

GDP. Thus, the change of a provision to manage the cycle is done only when the target is

outside the corridor. In this regard, judicious decision is very much needed to complement

the existing formal rule or to calibrate policy measures.

9 For example, the provision on the removal of allocation for productive assets (the loan-loss provision) tends to decrease when

the NPL ratio also tends to fall during the period of expansion. Financial market itself is procyclical as risk distribution tends

to narrow during the expansion phase and dilate, sometimes drastically, during the contraction phase. From the perspective of

risk management, policy instruments should ideally be applied as early as possible by taking into account the risks that may

appear in the event of deteriorating economic condition (based on observations of economic cycles). Some opinion suggests

that measures should be countercyclical, i.e., tightening during periods of expansion and loosening during periods of

contraction. In response to the crisis, the Basel Committee on Banking Supervision took a number of measures (in the context

of Basel III) to reduce procyclicality. These measures include (i) assessing and mitigating the effect of cyclicality of minimum

capital requirements, (ii) encouraging forward-looking provisioning, (iii) adopting a regulatory framework for capital

conservation and countercyclical buffer, (iv) introducing a minimum leverage ratio.

22

(iv) Effectiveness and calibration of policy measures

The effectiveness of how a policy instrument works will affect the calibration of the

selection of policy measures that are deemed appropriate. In contrast to the analysis of

monetary policy transmission, there has been no theoretical framework of macroprudential

policy that has been well developed or robust empirical results to guide the calibration. With

the uncertainty of the impact of a macroprudential policy instrument, the policy-making

authorities need to be pragmatic in the use of the instrument. This is certainly not easy in the

absence of no theoretical foundation and empirical research that describes how policy

measures must be adjusted in calculating potential risks that may arise.

The study on the results of the calibration of macroprudential policies in OECD

countries (Barrell, 2010) indicates that in general, macroprudential policies can be used to

address macroeconomic risks faced by banks, and simultaneously reduce the probability of

the occurrence of a crisis. Antipa et al. (2011) in the UK and U.S. case studies also concluded

that macroprudential policies are very effective for smoothing the credit cycle and prevent the

global financial crisis from bringing about deeper ramifications. Beyond these findings, one

particular thing that is important to note is the need for a compromise to enable a country to

make adjustments to the application of macroprudential instruments considering that

adjustments to instruments or regulations may also lead to the incurrence of costs including

the increase in funding costs and margins, thus negatively impacting on the increase in

economic activities. Thus, policy application needs to be performed in a proper dosage in

order to align the costs and benefits thereof with the risk control expected.

(v) Policy communication

Communication in the context of monetary policy and macroprudential integration is

very crucial and by no means an easy challenge. Firstly, conveying a message to the market

about the dangers of the growing imbalance in the financial sector during economic boom is

difficult because such message would be very unpopular in the midst of optimism of market

actors. Monetary policy response in the form of higher interest rates when there is no

inflationary pressure is politically and economically hard to accept because the central bank

can be considered jeopardizing the growth and interests of the people. Therefore, persuasive

communication to the public on the importance of long-term stability is very much needed.

Communication strategy for normal condition will not be able to be used under conditions of

excessive optimism. Communication of monetary policy needs to adjust to the ongoing

dynamics of the financial system. Here, the role of macroprudential policy that is rule-based

in supporting monetary policy makes the central bank’s task easier. With such support,

monetary policy only plays the role of giving signals rather than directly controlling the growing

23

risks in the financial sector. Secondly, economic uncertainties in the future, which are very

high especially during periods of turning points in economic cycles, pose a challenge for

policy communication.

5. Conclusion and Implication

In this paper we have discussed various underlying aspects of the linkage between

monetary and financial stability and a number of central issues that still need to be analysed

further, particularly in relation to the practical significance of the risk-taking behavior in

reshaping the work of monetary policy transmission mechanism. The discussion leads us to

the understanding that there are some strategic and tactical challenges facing central bank in

designing policy strategy to integrate monetary and macroprudential policy framework,

especially to meet the dual objectives of monetary stability (price) and financial stability. Given

the fact that the nexus between monetary and financial stability, whether they are substitutes

or complements, is still in an open debate, it is important to draw implications, especially

related to central bank policy mandate.

Adjustment of Mandate and its Consequences on Policy Governance

Learning from the crisis, in formulating a post-crisis monetary policy strategy the central

bank should increasingly strengthen its function in stabilizing the financial system to ensure

that the macroeconomy in stable condition. The shifting or the emphasizing of the central

bank’s mandate to maintain financial system stability has consequences on policy

governance. Unlike the format of the monetary policy governance that is generally understood,

as in the application of the ITF, the format of the policy governance of financial system stability

is not yet fully understood. Adoption of financial system stability as a major or additional aspect

in the implementation of the responsibilities of the central bank may give rise to complications

in the format of the central bank’s policy governance. Hence, it is by no means easy to design

the central bank’s mandate to maintain the stability of both prices and the financial system at

the same time.

There are several underlying reasons for complications in the central bank policy

governance (Crockett, 2010). Firstly, there is no firm and quantified understanding of the

objectives of financial stability as understood in the objectives of price stability. Thus, there

has been no benchmark on how to assess the central bank’s success in fulfilling the

responsibility to maintain financial stability. Secondly, the responsibility for maintaining

financial system stability is essentially multidimensional. The scope of such responsibility

starts from prudential supervision, the establishment of policies to prevent systemic risks to

liquidity support in the financial market and individual financial institutions. In this regard, there

is no clear governance model that accommodates differences in the characteristics of each of

24

these steps. Thirdly, decisions related to financial system stability tend to be politically

sensitive, as compared to monetary stability. This makes it difficult to align the interest to

maintain the independence with the response to the existing political environment. In this case,

the toughest challenge faced by central bank in an effort to maintain independence is how

action taken by the central bank, especially in areas outside the central bank’s mandate, could

finally be officially accepted and legitimized by the government or the parliament.

In relation to this thinking, one of the issues raised is related to how to place a mandate

to maintain financial system stability in the monetary policy framework. One of the alternative

monetary policy formats that can be drawn up is to continue making price stability as the main

element that affects monetary policy response. However, the substance of price stability has

expanded to accommodate financial stability indicators and has a broader forward-looking

horizon.

Another alternative policy format is to establish the strengthening of financial system

stability as one of the mandates on monetary policy, in addition to maintaining price stability.

In respect of this, Svensson (2010) asserts that there is a close linkage between the

achievement of monetary stability and financial system stability. Financial system stability

directly affects the financial market, and financial market condition will affect the effectiveness

of monetary policy transmission mechanism. If the financial market is in trouble, it may affect

real economic activities drastically, as indicated by the occurrence of financial crises.

Meanwhile, monetary policy affects bank balance sheets and asset prices, which in turn

affects the stability of the financial system. However, in spite of being interrelated, both have

conceptual differences, both in terms of the objectives, instruments used and the responsible

authorities. Thus, it is rather unreasonable to refer to the achievement of financial stability as

part of monetary policy mandate.10

Hence, some views (such as Svensson (2010), Hannoun (2010), and Jordan (2010))

suggest that price stability should be the main objective of monetary policy. Meanwhile, the

substance of financial system stability, particularly in its relation to macroprudential policies,

should be calculated carefully and efforts should be made to prevent the achievement of policy

goals that are too ambitious, for example through over-regulations on the development of

asset prices and credit growth. One initial step to address this situation is through the use of

macroprudential instruments to address the apparent imbalance in credit and asset markets.

In the future, in line with the policy practice of the use of various macroprudential instruments

10 Beyond that, as argued by Blinder (2010) and Nyberg (2010), such conceptual difference does not negate the possibility of

gains from the implementation of responsibility, which is very great, for maintaining financial system stability by the central

bank.

25

along with monetary instruments, a more appropriate policy mandate can be formulated on

the basis of past experiences.

Mandate for the Implementation of Macroprudential and Microprudential Policies

In carrying out its functions to achieve and maintain financial system stability, central

banks will require supporting instruments in the form of macroprudential and microprudential

supervision. Macroprudential supervision refers to the process of managing the overall

soundness of the financial system which is carried out through a series of analysis of behavior

in the financial sector and financial market conditions. This management process is

implemented by designing policy architecture and response to the ongoing condition of the

financial system. Meanwhile, microprudential supervision is the process of individually

managing the soundness of financial institutions which is carried out through the application

of supervision and regulation that is expected, in aggregate, to be able to create continuity

and stability in the financial system and to provide protection to consumers.

The crisis has also provided a lesson that close coordination between microprudential

supervision and macroprudential supervision in formulating appropriate and expeditious

policies at crucial times is required. Macroprudential supervision is directed to the activities of

financial institutions, both banks and non-banks, which have a significant influence on both

the financial market and the financial system. In macroprudential supervision, monitoring of

macro indicators is conducted as a means to monitor, anticipate and mitigate various

anticipated risks that may threaten the stability of the financial system and the real economy

as a whole. In addition, the monitoring of macroprudential condition may also provide

information on systemic risks and mitigate the spreading effects of disturbances occurring in

financial institutions that may interfere with the business cycle. Information obtained from this

macroprudential supervision will assist policy makers with whether or not it is necessary to

rescue a financial institution that is experiencing a lack of liquidity. In practice, the authority

carrying out the monitoring of macroprudential condition requires a fast and easy access to

information, micro data and unimpeded official authority to acquire any additional data if

needed.

Given the linkages between microprudential policy and macroprudential policy, does

this also mean that the central bank also needs to be given the responsibility to implement

microprudential policies? Those arguing for and against the need for central banks to

implement microprudential policies are still continuing their debates until today. Substantively,

it can be understood that the most important thing for the effectiveness of central banks in

maintaining financial system stability is the continuity of the flow of exchanges and the quality

of information between microprudential and macroprudential supervisory agencies, given that

26

the functions of both agencies are complementary. In light of this, the feasibility of information

exchanged depends on the institutional framework of the agencies, their habits and human

factors.

Thus, if the central bank is not mandated to implement microprudential policies, then

close coordination between the central bank and the competent authorities in the

microprudential supervision sector is absolutely necessary. In other words, coordination is as

necessary as maintaining consistency and harmony among the achievement of the goals of

monetary, macroprudential and microprudential policies. In this case, macroprudential policy

has an extremely vital role both in supporting monetary policy in maintaining macroeconomic

stability and microprudential policy. Macroprudential policy in a narrower dimension requires

consistency in the use of microprudential instruments while macroprudential policy in a

broader dimension requires consistency with monetary policy.

The above mentioned view has very significant implications on the institutional

mandate of Bank Indonesia whereby the banking supervision function is separated from Bank

Indonesia and turned over to a new institution, that is, the Financial Services Authority (FSA).

The paradigm that monetary policy needs to be supported by macroprudential policy brings

the consequences that the two policies cannot be separated in order for both to operate

effectively.

After the establishment of FSA, macroprudential policy framework shall inevitably

involve two institutions, that is, Bank Indonesia and the FSA which is authorized to regulate

and supervise microfinance institutions. Bank Indonesia has the ability to assess

macroeconomic risks and global financial market developments. Meanwhile, the FSA has

information about individual financial institutions. Therefore, in order for the system to function

properly, there must be a mutual exchange of information between Bank Indonesia and the

FSA.11 The FSA must provide all information related to the monitoring of individual risks

whereas Bank Indonesia has macroprudential assessment that must be submitted to the FSA

to be implemented at an individual level.

11 Arguments for and against the need for central banks to implement microprudential policies are still continuing to develop

until today. Substantively, it can be understood that the most important thing for the effectiveness of central banks in

maintaining financial system stability is the continuity of the flow of exchanges and the quality of information between

microprudential and macroprudential supervision, given that the two have complementary functions. Pertaining to this,

information that is feasible depends very much on institutional form, habits and the human factor. Thus, if a central bank is

not mandated to implement microprudential policies, close coordination between the central bank and the competent

authorities in the microprudential supervision sector is absolutely necessary.

27

28

III. COUNTRY ECONOMIC PROFILE

3.1. Indonesian Economic Profile

A. Country Background

The Republic of Indonesia is located in Southeast Asia and Oceania. Indonesia is an

archipelago comprising approximately 17,508 islands with over 238 million people, making

it the world's fourth most populous country. The country shares land borders with Papua New

Guinea, East Timor, and Malaysia. Other neighboring countries include Singapore, the

Philippines, Australia, Palau, and the Indian territory of the Andaman and Nicobar Islands

(Exhibit 1). The Indonesian archipelago has been an important trade region due to its strategic

location between Asia and Oceania. In its history, Indonesia is also famous with natural

resources which attracted many foreigners, especially from Europe. Following three and a half

centuries of Dutch colonialism which is known as Dutch East Indies, Indonesia secured its

independence in August 17, 1945 after World War II. Indonesia is a founding member of

ASEAN and a member of the G-20 major economies. The Indonesian economy is the world's

16th largest by nominal GDP and the largest in South East Asia.

As an open economy, Indonesia once became an example of many developing

countries because of its improvement. However, the Asian financial crisis of 1997/98 hit

Indonesia really hard, forcing Indonesian economic growth to decline to a negative growth of

13.1% and inflation to jump to 58%. The cost of recovery to sustain banking sector

improvement was around 50% to GDP, among the biggest number in the crisis history. Having

pursued various stabilization programs, Indonesian economy gradually indicated a very good

recovery. The Gross National Income (GNI) per capita has reached USD 3,420 by the end of

2012, approaching the upper-middle income country and is categorized as a lower middle

income economy according to the World Bank Country Income Classifications12. The country

has a large pool of working age population which consist 63.20% of the population

(Exhibit 2). Its income per capita and share of middle class population have been increasing

in the past five years then encourages the strengthening of domestic demand. About 5 of the

10 people in Indonesia are in the middle class. Potential market is huge and continues to grow

into the investment attractiveness. In addition, the growing middle class has changed their

consumption pattern, from basic food into primary goods even further into secondary goods

and tertiary goods.

12 See World Bank classification (Atlas Method) in http://data.worldbank.org/about/country-classifications

29

B. Macroeconomic Policy and Monetary Policy Regime13

Taking into account the progress of Indonesian economic development over the last

three decades, many agreed that the structural transformation of Indonesian economy could

be regarded as a ‘miracle’. The Indonesian economy entered the 1980s on the crest of a

sustained boom in oil world oil export earnings. From a predominantly agrarian economy,

escalating oil revenues held the promise of accelerated growth and a rapid transition to the

path of industrialization which had proved so successful to other countries in the Pacific region.

Likewise, an open capital account has been adopted since 1982 to encourage foreign

investors in order to close in the savings-investment gap.

Amid the increasing economic integration, the choice of exchange rate regime, along

with the implementation of monetary policy strategy, is one of the key issues in open-economy

macroeconomics. In Indonesia’s case, financial globalisation was a key factor driving growth,

which gained momentum each time financial liberalisation moved up to the next rung. This

was the prevailing wisdom, at least during periods prior to the 1997 financial crisis. However,

the outbreak of the crisis in mid-1997 challenged this claim. The Asian financial crisis of

1997/98 proved to be more severe, prolonged and difficult for Indonesia than for other

countries in the region. Triggered by sharp depreciation of Rupiah, the crisis led to

unprecedented economic collapse. In 1998, the economy shrank while inflation soared. Banks

and businesses failed in rapid succession, leaving behind large numbers of newly

unemployed.

In the early days of the crisis, the Government attempted to shore up the battered

Rupiah by gradual widening the intervention band and intervening on both the forward and

spot markets. The policy response taken was essentially in line with the intention to maintain

the free foreign exchange regime adopted by Indonesia since the early 1980s. However,

as efforts to defend the currency against overwhelming pressure became increasingly futile,

the Government finally allowed the exchange rate to float freely in mid-August 1997. Soon

after floating the currency, the government instituted an extreme tight money policy through

dramatic increases in interest rates sharply while also suspending activity in expansionary

instruments.

Soaring interest rates and steep depreciation dealt severe blows to banks and the real

sector. Already in fragile condition, banks saw rapid deterioration in asset quality while many

13 Main References: Monetary Policy Regime in Indonesia: towards A Post-GFC Framework (Solikin M. Juhro

and Miranda S. Goeltom), in Monetary Policy Regime in Pacific Region, Routledge International Publisher,

London (forthcoming).

30

companies were forced to close. To prevent runs on banks and a collapse of the entire

banking system, Bank Indonesia extended massive liquidity support to commercial

banks. As the public quickly lost confidence in the Rupiah, a cycle of currency depreciation,

soaring prices and expanding money supply threatened to spiral into hyperinflation. Bank

Indonesia’s principal objective was therefore to restore confidence in the national currency.

To achieve these aims, monetary expansion first had to be halted. Bank Indonesia also

needed to regain control over its own balance sheet. All sources of money creation by the

central bank needed to be brought under control and excess liquidity reabsorbed from the

banking system.14

Because of various factors hampering the effectiveness of money market instruments,

such as the thin market for SBIs, the excess liquidity in the economy could not be fully

absorbed in open market operations (OMOs).15 Another innovation in enhancing monetary

policy operations was ‘Rupiah intervention.’ This was introduced as a means of monetary

restraint and as a fine tune instrument to counteract interest rate volatility in the interbank

money market. Rupiah intervention thus not only served as a contractionary instrument but

also to promote monetary expansion. Attempts to control the monetary expansion from

liquidity support originating in government expenditures were also supported by sterilisation

in the foreign exchange market, which simultaneously increased the supply of foreign

exchange, thereby helping to stabilise the domestic currency. To sum up, Bank Indonesia

adopted base money targeting after the crisis as a temporary framework that sought

primarily to absorb the monetary expansion originating from liquidity support, rather than for

more fundamental considerations such as maintaining a stable relationship between inflation

and base money.

The Post Asian Financial Crisis Monetary Policy Framework

A ground breaking change in the conduct of monetary policy in the aftermath of the

crisis came with the new Bank Indonesia law of 1999, prescribing full independence in policy

formulation and implementation. The most important provision in the law, other than legally

establishing Bank Indonesia as an autonomous state institution free from government

14 To curb expansion in liquidity support, Bank Indonesia acted in April 1998 to impose a stiff penalty on the

discount window facility and negative balances held by commercial banks at Bank Indonesia. In May 1998, Bank

Indonesia announced a ceiling on deposit rates and interbank rate guaranteed by the government to prevent banks

from adopting imprudent measures that would lead to self-reinforcing expansions of liquidity support.

15 The first attempts to achieve the quantitative target involved improvements to the OMO mechanism. On 29 July

1998, Bank Indonesia changed the SBI auction system from emphasis on interest rate targets to quantitative

targets. Auction participants, formerly restricted to primary dealers, were expanded to include bankers, money

brokers, securities houses and the general public. These changes were intended to promote competition among

auction participants, enabling the SBI rate to better reflect the interaction between demand and supply.

31

intervention, the establishment of a single monetary policy objective of achieving and

maintaining the stability of Rupiah. To achieve this objective, the law empowered Bank

Indonesia to execute monetary policy by setting monetary targets—with due consideration of

the inflation target—and managing monetary aggregates. In other words, Bank Indonesia was

vested with both goal independence and instrument independence. Another important change

in the new law was the prohibition on central bank financing of government deficit spending

and on purchasing government bonds on the primary market. However, the central bank was

permitted to buy bonds on the secondary market for monetary policy purposes.

Having experienced a transition period of ITF during 2000 to 2005, Bank Indonesia

formally adopted the ITF in July 2005, with a more transparent communications strategy

aimed at strengthening monetary signals with the use of interest rates, namely the Bank

Indonesia rate (BI Rate) as the policy rate and short term money market rate as the

operational target. Under this new framework, Bank Indonesia envisages the strengthening

of the policy-making and implementation mechanisms through a forward-looking strategy for

pursuing the inflation target. This, as expected, will alleviate inflation expectations. Because

the monetary instruments must be easily understood by the public, interest rates are the

preferred choice. This choice stems from the greater clarity in the interest rate policy signal,

which makes it easier to shape public expectations. Furthermore, because inflation in

Indonesia is driven significantly by supply factors, bringing inflation down by influencing

expectations will have minimal impact on overall demand.16

Going forward, the implementation of monetary policy must ultimately decide between

flexibility on one hand and credibility and transparency on the other. Within these bounds,

certain discretion will be needed to help with Indonesia’s short-term problems. Nevertheless,

excessive flexibility—for example, that leads to unclear changes in policy decisions—would

undermine the credibility and policies of the central bank. Looking ahead, it can only be

expected that consistent commitment and determined implementation will be essential to the

realisation of a more credible ITF. In the meantime, despite progress since the crisis, the

economy is still burdened by various constraints and problems both from demand and

supply sides. The main challenges confronting the Indonesian economy are to maintain

stability amid rising global uncertainty and to reduce unemployment and poverty through

16 The decision to use of interest rates as the operational target under the ITF was not based solely on the need to

influence expectations. Interest rates also have the advantage of measurability. In this sense, they offer greater

accuracy, speed and clarity compared to base money. Interest rates are also easier to control than monetary

aggregates, which often appear somewhat unstable. This control can operate through liquidity adjustments and

direct signalling to guide public expectations. A further advantage is the ability of interest rates to affect the

ultimate target. Several studies show that interest rates contain strong information on inflation and have the

capability to curb inflation through various transmission channels. That said, interest rates can only produce

optimum results in policy signals if public expectations are forward-looking.

32

accelerated growth. In this regard, the challenge in monetary policy is to contain rising

inflationary pressures without impeding economic growth.

The Post-Global Financial Crisis (GFC) Monetary Policy Framework

The GFC of 2008/09 have revealed some valuable lessons for monetary policy

implementation in Indonesia. First, the multiple challenges facing monetary policy as a result

of deluge capital inflows imply that Bank Indonesia should employ multiple instruments. This

instrument mix allows Bank Indonesia to address multiple dilemmas. Second, while price

stability should remain the primary goal of Bank Indonesia, the GFC demonstrated that

maintaining low inflation alone, without preserving financial stability, is insufficient to achieve

macroeconomic stability. A number of crises that have occurred in recent decades also show

that macroeconomic instability is primarily rooted in financial crises. Third, exchange rate

policy should play an important role in the ITF of a small open economy. In a small open

economy with open capital movement, exchange rate dynamics are largely influenced by

investor risk perception, so that there is a case for managing exchange rate in order to avoid

excess volatility.

Bank Indonesia considers that ITF remains a reliable monetary policy strategy in

Indonesia, yet given the dynamic and complexity of challenges we are facing, it needs to be

enhanced by refining the future ITF implementation strategy (Juhro and Goeltom, 2012). There

are five principles of ITF enhancement, as follows:

a. The policy framework continues to adhere to an inflation target as the overriding

objective of monetary policy. The main characteristics of ITF will remain, e.g. preemptive,

independent, transparent and accountable policy implementation.

b. Monetary and macroprudential policy integration. Appropriate monetary and

macroprudential policy integration is required in order to buttress monetary and financial

system stability.

c. Managing the dynamics of capital flows and exchange rates. To support

macroeconomic stability, coordinated implementation of a policy instrument mix is

ultimately part of an important strategy to optimally manage monetary policy trilemma.

d. Strengthening policy communication strategy as part of policy instruments. Policy

communication is no longer for the sake of transparency and accountability, but further as

a monetary policy instrument.

e. Strengthening Bank Indonesia and Government policy coordination. Policy

coordination is crucial considering that inflation stemming from the supply side creates the

majority of inflation volatility.

33

C. Macroeconomic Developments and Financial System Stability

1. Output

In the midst of crises, Indonesian economic growth remains strong, posted an

average of 6.0% in the last-5-years, showing resilience amidst sharp fall in export as a

result of pressures from the global economic slowdown. The leading source of Indonesian

economic growth has been its strong domestic growth with increasing role from average

of 80 percent in pre 1997/98 Asian Crisis to 90 percent in the post-crisis. In 2013, the

economy expanded at 5.81% (yoy), slower than earlier period of 6.23% (yoy) (Exhibit

4). Source of growth has a more balanced composition, driven mainly by higher export and

moderated domestic demand. This is in line with the stabilization policy devised by BI and

the Government to bring the economy to a healthier level. In 2013, household consumption

grew by 5.24% (yoy), and still as a backbone of the economic growth.

Despite having hit by the Asian financial crisis of 1997/98, manufacture sector

remains the biggest share in economic growth (Exhibit 5). Manufacturing sector

expanded in line with rising domestic demand, as reflected on the production within food

and beverage, transport, cement, and chemical subsectors. However, the manufacture

sector’s share in the economy continues to decline due to contraction in export and

switching other sector such as mineral and services sector such as trade, hotel and

restaurant. Mining also declined in share to the economy. This was caused by a lower than

targeted level of oil production due to natural production deterioration in addition to

disruption in production. Trade, hotel and restaurant sectors managed to gain share in the

economy as well as Transportation and communication. From the spatial perspective, high

growth was mainly took place in the eastern part of Indonesia (Exhibit 6). Such a high

growth level in the region was supported by natural resources based export and rising

infrastructure investment.

2. Inflation

Inflation in Indonesia has indicated a downward trend over a longer term.

This was evidently reflected from the declining trend of core inflation notably from average

of 7.4% in 2002 – 2006 to 5.2% in 2007 – present. Volatile food and administered price,

particularly fuel price, is the main driver of the inflation (Exhibit 7). CPI inflation in 2013

reached 8.38% (yoy), above its target band (4,5±1%) due to subsidized fuel price

hike in administered price inflation and food price fluctuation. Nevertheless,

inflationary pressures eased since September 2013. Bank Indonesia and Government’s

policy responses have successfully brought inflation back to its normal path.

34

Core inflation was remained under control because of slight inflationary

pressures from both domestic and external, and also moderation in the inflation

expectations. In 2013 core inflation stood at 4.98% (yoy). The pressures on core inflation

took place in a number of periods mainly came from the second round effect of

administered price such as LPG price and fuel price increased by the government which

affected the food processed inflation. Moreover, depreciation of the exchange rate also

has some impact to theimported price. Inflation in volatile food mainly came from volatility

on price of horticulture product due to the supply. Administered price mainly came from

energy price increased.

3. Exchange Rates and the Balance of Payments

After four consecutive years of surpluses, Balance of Payment in 2013

returned to negative territory by posting US$7.3 billion deficits (Exhibit 8). Such

pressure is contributed by increased deficit in current account and decreased surplus in

capital account. Pressure on Balance of Payment was induced by mounting current

account deficit of 3.5% of GDP in 2013, up from 2.8% of GDP 2012. However,

improvement was noted in Q4/2013 as current account deficit eased and capital & financial

account recorded a surplus. Policy responses by BI and the Government had left favorable

impact on Balance of Payment.

Global economy slowdown and plummeting commodity price led to weak exports

performance. Export in 2013 is recorded declining 2.62% compared to 2012. This

contributed to higher current account deficit due to lower surplus in trade balance.

Meanwhile, income account and services account had been in persistent deficit.

Export is dominated by manifacture products and mining (Exhibit 9). Main commodities

of export are coal, Palm oil and textile & textiles products. Import, on the other hand, also

declined but in slower paced then export. Import declined 1.38% in 2013 compared to

2012 and mainly raw materials and auxiliary goods (Exhibit 10).

Uncertainty in the global financial market as an impact of the tapering of

quantitative easing policy, caused a declining on capital and financial account. Surplus

in 2013 is recorded US$22.7 billion, decreased from US$ 24.9 billion in 2012 (8.70%)

(Exhibit 11). The peak of pressures occured in May – August 2013 where the capital

outflow from the domestic financial market accumulated to US$ 8 billion.

In response to the these condition, Indonesia’s official reserve assets stood at

$99.4 billion in December 2013, which should cover 5.4 months of imports and

servicing of government external debt above international standard for adequacy of 3

months import (Exhibit 12). Although declined from 2012 of US$ 112.8 billion,

35

international reserves has maintained an upward trend since August 2013 and this has

sthrengthened Indonesia’s external resilience.

Rupiah depreciated throughout 2013 and experienced higher volatility. Point-to-

point, Rupiah in 2013 weakened by 20.8% (yoy) to Rp12,170 per USD or depreciated

10.4% (yoy) on average to Rp10,445 per USD (Exhibit 13). Pressures on rupiah was most

notable on the period of May to August 2013, in line with high intensity of capital outflow

due to surge of domestic inflation, investors’ concern on the prospect of current account,

and the global negative sentiment on the Fed tapering plan.

4. Interest Rate

Indonesian Economy faced a big challenge due to the mounting pressure on

macroeconomic stability. Throughout 2013, Bank Indonesia pursued a tightened

monetary policy stance by raising the BI rate by 175 bps to 7.50%, in order to mitigate

inflationary pressure and guide an adjustment in the current account deficit toward a more

sound and sustainable level. The increases in the BI rate were also passed on to bank

interest rate (Exhibit 14). As of December 2013, time deposit rates recorded an increased

193 bps at 7.69% compare to December 2012. Weighted average of lending rates has

also increased 23 bps to 12.39% compare to December 2013. Therefore, the spread

between loan and deposit rates narrowed to 470 bps in December 2013 from 640 bps in

December 2012.

5. Monetary Aggregates

In keeping with slowing growth in the domestic economy and rising bank interest

rate during 2013, economic liquidity has charted a more subdued course (Exhibit 15).

In December 2013, broad money (M2) was recorded Rp3,727 trillion, increased 12.07%

from December 2012, narrow money (M1) was recorded Rp887 trillion, increased 5.40%

from December 2012. Less vigorous M1 can be explained primarily from slowing growth

of demand deposit. The slowing down of the liquidity can also be observed from the

decreasing of monetary operation absorption, which usually used to indicate excess

liquidity, which recorded Rp274 trillion in December 2013 from Rp429 trillion in December

2012.

6. Financial Institutions

The banking industry continues to play a significant role in the financial

system of Indonesia (Exhibit 16). The share of the banking industry amounted to 78,5%

in December 2013, which represents a slight expansion compared to that reported in the

previous year at 78.3%. The decreasing share of the banking industry primarily due to the

36

increase of the burgeoning assets of non-bank financial institutions, such as finance

companies, insurers, capital venture firms and pawnbrokers. The expanding share of

finance companies was due, among others, to tenaciously strong public demand for

automotive loans underwritten by such firms. Looking forward, the role of non-bank

financial institutions is expected to expand in Indonesia through efforts towards financial

deepening along with greater public interest in financial products that are not banking

products.

It should be noted that starting early 2014, banking regulatory and supervisory

functions are under the Financial Services Authority/FSA (Otoritas Jasa

Keuangan/OJK), no longer under Bank Indonesia. In this regard, Bank Indonesia still acts

as macroprudential authority, while the FSA acts as microprudential authority. Bank

Indonesia has the ability to assess macroeconomic and financial stability risks as well as

global financial market developments, while the FSA has the ability to assess individual

financial institution risks. Therefore, macroprudential policy framework shall inevitably

involve these two institutions. This is due to the fact that the implementation of

macroprudential policy requires consistency in the use of microprudential instruments. In

order for the system to function properly, there must be a close coordination between Bank

Indonesia and the FSA.

7. Bank Funding and Financing

The funding structure of banks remained dominated by deposits (Exhibit 17).

Up to December 2013, the share of deposits as the primary source of funds reached

78.07% of the total funding. Meanwhile, retained earning counted as 4.45% of the total

funding. Other funding components only account for negligible shares, namely loans,

securities, other liabilities as well as liabilities held at Bank Indonesia and security deposits.

Bank deposits increased Rp3,663.97 trillion (13.60%) in December 2013 compared

to Rp3,225.20 trillion in December 2012 (Exhibit 18). The deposit is still dominated by the

short-term deposit such as demand deposit, saving deposit and up to 1 month time deposit

that counted to Rp2,684.7 trillion (75.08% of the total deposits).

As the economy slipped and interest rates rose, credit growth decelerates. Credit

grew by 21,35% in December 2013, down from 23.1% in December 2012 (Exhibit 19).

Based on types, the credit slowdown mainly occurred in working capital and investment

credit. Based on sectors, slowdown is primarily seen in Trade, Hotel, and Restaurant and

other consumption loan.

37

8. Banking Resilience

Liquid assets, which is indicated on liquid asset to total asset ratio, was

recorded a declined to 15.77% in December 2013 compare to 19.73% in December 2012

(Exhibit 20). This was caused by the rapid credit growth on banking sectors which was

indicated by the loan-to-deposit ratio in December 2013 was 90.55%, increased from

84.72%. The decline in liquid assets stemmed from a decrease in secondary reserves,

consisting of Bank Indonesia Certificates (SBI), other placements at Bank Indonesia,

trading SUN and available-for-sale SUN, as well as decline in primary reserves,

comprising of cash and bank checking accounts held at Bank Indonesia.

Amid flagging economic growth that has led to reduced credit expansion,

banking industry resilience has remained firm. The solid banking resilience of the

banking industry is reflected in the high level of the capital adequacy ratio (CAR) at

18.36% in December 2013 (Exhibit 21), well above the minimum 8% regulatory minimum.

Amid efforts to expand the intermediation function, bank credit risk remained

low. The gross NPL ratio of banks at December-2013 was 1.77%, which is relatively

stable compared to the previous semester but lower than during the same period of the

preceding year (Exhibit 22).. The slowdown was due to a selective credit allocation

process implemented in the banking sector. Consequently, the rate of credit growth

outpaced the increase in non-performing loans.

9. Stock and Bond Markets

Domestic stock market closed with relatively stable performance. At the end

of December 2013, Jakarta Composite Index (JCI) was closed at 4,274 or declined 0.98%

from 4,317 (Exhibit 23). Big pressures came from the net selling of foreign investor that

peaked on June 2013. The wave of foreigner selling was triggered by fears of accelarating

the Fed tapering and negative domestic sentiment. For the year of 2013 overall,

Indonesia’s stock market sustained net foreigner selling of Rp20.65 trillion.

Similar with the pressure on stock market, the Indonesian Government bonds also

faced the pressures from foreign investors’ net sale. Hence, yields up by 313.12 bps from

5.16% in December 2012 to 8.29% in December 2013 (Exhibit 24). In December 2013,

foreign investor net sells was recorded Rp0.37 trillion.

10. Financial System Stability Index

38

Pressures on financial markets intensified towards the end of semester I-

2013, however, well maintained stability at financial institutions helped limit the

impact of such pressure until the end of 2013. The buildup of pressure in semester I-

2013 was clearly reflected by the Financial System Stability Index (FSSI) (Exhibit 25).

Based on a recent review, although the FSSI remained normal, index performance

required close monitoring in August 2013. Disaggregating the FSSI demonstrates that the

spike in the index was triggered by pressures on financial markets, while conditions at

financial institutions remained normal. Pressures on financial markets were exacerbated

by the tapering policy of the US Federal Reserve Bank, which manifest as rupiah

depreciation against the US dollar. Meanwhile, pressures also mounted on the bond

market (bond yield) as well as the stock market (IDX Composite) and liquidity risk

intensified on the interbank money market.

D. Bank Indonesia Policy Instrument Mix (2010 – 2012)

39

Policy Instrument Policy Response Rationale

1. Interest rate policy • BI Rate increase by 25 bps to 6.75% in February 2011.

• BI Rate cut by 75 bps to 6.0% in Q4-2011

• Response over increasing inflation pressures from food prices and inflation expectation.

• To provide stimulus in anticipating the impact of global economic slowdown (crisis) on domestic economy, provided that future inflation remains on the target.

2. Exchange rate management

Rupiah appreciation is tolerated manageably, in line with regional currency movement .

• To stabilize exchange rate and help mitigating imported inflation, while it does not exarberate imports and negate the economic growth.

3. FX reserve accumulation

FX reserves increased from USD 66 bio at end-2009 to USD 96 bio at end-2010. Further increase to USD119 (6.8 month of import and short term public debt repayment) by end of June 2011.

• As a self insurance against risks of sudden reversals of capital inflows. In part as implications of FX intervention to stabilisize exchange rate.

4. Macroprudential on capital infows

a. One Month Holding Period (OMHP) on BI bills since June 2010 and 13 May 2011 to Six Months Holding Period.

b. Shifting BI bills to Term Deposit since June 2010.

c. Increase FX Reserve Requirement from 1% to 5% March 1st, 2011, to 8% June 1st, 2011.

d. Reinstating limit offshore short term borrowing of banks to 30% capital, end Jan 2011,with 3 months transition period.

e. Revocation BI direct FX supply to domestic corporate

• To “put sand in the wheels” on short-term and speculative capital inflows, and mitigate risks of sudden reversals.

• To lock up domestic liquidity to longer term, and limit the supply BI bills.

• To enhance bank FX management liquidity in responding to increase in FX exposure due to capital inflows, while support monetary operations in managing liquidity and stabilize exchange rate.

• Limit capital inflows to financial assets and encourage a shift to longer term offshore borrowing.

• Domestic FX liquidity back to normal and further deepen FX market liquidity.

5.Monetary operation enhancement and macro-prudential on liquidity/ financial system stability

a. Lengthen interval of auction (from weekly to monthly) and offer longer BI Bills maturity from 1 and 3 month to 9 month since August 2010.

b. Increase Rupiah reserve requirement from 5% to 8%, effective Nov 2010.

c. Reserve requirement link to Loan to Deposit Ratio (78 -100), effective March 1st, 2011.

• To enhance the effectiveness of domestic liquidity management, including from capital inflows, by locking up to longer term and in the same time help develop domestic financial markets.

• To absorb domestic liquidity and enhance banks’s liquidity management, without exerting negative impact on lendings that are needed to stimulate growth.

• Prudential measure to enhance role of banking intermediation to support economic growth, while maintaining prudent banking operation.

40

3.2. Indonesian Economic Chart Pack

41

42

43

44

Figure 11. The Balance of Payments (in Million USD)

45

46

47

48

49

50

Loan Growth (%) yoy

51

52

53

54

References

Altunbas, Yener, Leonardo Gambacorta, and David Marques-Ibanez (2009), “An Empirical Assessment of The Risk Taking Channel”, paper presented on the BIS/ECB Workshop on “Monetary Policy and Financial Stability”–Basel, September.

Antipa P., Mengus E. and Mojon B. (2011), “Would Macro-prudential Policies Have Prevented the Great Recession?”, Banque de France mimeo.

Baliño, Tomás J. T. and Lorena M. Zamalloa (1997), “Instruments of Monetary Management: Issues and Country Experiences”, International Monetary Fund.

Barrell, R., Davis, E.P., Karim, D., and Liadze, I. (2010), “Calibrating Macroprudential Policy”, Discussion Paper No 354, National Institute of Economic and Social Research.

Bernanke, B.S. and M. Gertler (1999), “Monetary Policy and Asset Volatility”, Federal Reserve Bank of Kansas City Economic Review, 84(4), pp. 17-52.

Blinder, Allan S. (2010), “How Central Should the Central Bank Be?”, Princeton University CEPS Working Paper No. 198, January.

Borio, Claudio, Craig Furfine and Philip Lowe (2001), “Procyclicality of the Financial System and Financial Stability: Issues and Policy Options”, Bank for International Settlements (BIS) Paper No. 1.

Borio, Claudio (2003), “Towards a Macroprudential Framework for Financial Supervision and Regulation?”, BIS Working Paper No. 128, December.

Borio, Claudio and Ilhyock Shim (2007), “What Can (Macro-)Prudential Do to Support Monetary Policy?”, BIS Working Paper No. 242, December.

Borio, Claudio and Haibin Zhu (2008), “Capital Regulation, Risk Taking and Monetary Policy: A Missing Link in the Transmission Mechanism”, BIS Working Paper No. 268, December.

Born, Benjamin, Michael Ehrmann and Marcel Fratzscher, (2010), “Macroprudential Policy and Central Bank Communication”, the European Central Bank Working Paper, September version.

Committee on the Global Financial System (2010), “Macroprudential Instruments and Frameworks: A Stocktaking of Issues and Experiences”, CGFS Papers No 38, May.

Craig, R. Sean, Davis, E3 Philip and Garcia Pascual, Antonio, (2006), “Sources of Pro-cyclicality in East Asian Financial Systems”, Economics and Finance Discussion Papers, Economics and Finance Section, School of Social Sciences, Brunel University.

Crockett, Andrew (2010), “What Have We Learned in the Past 50 Years about the International Financial Architecture?”, Address at Symposium to mark the 50th Anniversary of the Reserve Bank of Australia.

De Nicolò, Gianni, Giovanni Dell’Ariccia, Luc Laeven, and Fabian Valencia (2010), “Monetary Policy and Bank Risk Taking”, IMF Staff Position Note, SPN/10/09, July.

Geraats, Petra M. (2010), “Price and Financial Stability: Dual or Duelling Mandates?”, University of Cambridge.

Group of Thirty (2010), “Enhancing Financial Stability and Resilience: Macroprudential Policy, Tools, and Systems for the Future”

Goldfajn, Ian and Poonam Gupta (2002), “Overshootings and Reversals: The Role of Monetary Policy”, in Leonardo Hernandez and Klaus Schmidt-Hebbel (Eds.), Banking, Financial Integration, and International Crises, Bank of Chile, Santiago-Chile.

55

Hannoun, Hervé (2010), “The Expanding Role of Central Banks Since The Crisis: What are The Limits?”, Speech at the 150th Anniversary of the Central Bank of the Russian Federation, BIS.

Issing, Otmar (2003), “Monetary and Financial Stability - Is There a Trade-Off?”, Speech at the Conference on “Monetary Stability, Financial Stability and the Business Cycle”, Bank for International Settlements, Basel.

Jordan, Thomas J. (2010), “A Changing Role for Central Banks?”, Speech at the Welcome Event Master of Banking and Finance, St. Gallen, September, BIS.

Miskhin, Frederic S. (1991), “Asymmetric Information and Financial Crises: A Historical Perspective”, NBER Working Paper No. 3400, August.

Mishkin, Frederic S. (2009), “Is Monetary Policy Effective during Financial Crises”, American Economic Review, 99 (2).

Moreno, Ramon (2011), “Policymaking from A “Macroprudential” Perspective in Emerging Market Economies”, BIS Working Papers No 336, January.

Nier, Erlend and Lea Zicchino (2008), "Bank Losses, Monetary Policy and Financial Stability—Evidence on the Interplay from Panel Data," IMF Working Papers 08/232, International Monetary Fund.

Nijathaworn, Bandid (2009), “Rethinking Procyclicality: What is It Now and What Can be Done”, Paper presented at BIS/FSI-EMEAP High Level Meeting on Lessons Learned from the Financial Crisis – An International and Asian Perspective, 30 November 2009, Tokyo, Japan.

Nyberg, Lars (2010), “After the Crisis – New Thoughts on Monetary Policy”, Speech at Nordea, Stockholm, Sveriges Riksbank.

Schwartz, Anna J. (1995), “Why Financial Stability Depends on Price Stability”, Economic Affairs, Volume: 15 Issue: 4.

Svensson, Lars E.O. (2010), “Inflation Targeting after the Financial Crisis”, Speech at the International Research Conference Challenges to Central Banking in the Context of Financial Crisis, Mumbai, February.

56

APPENDIX 1

A SMALL MACROECONOMIC MODEL FOR POLICY EXERCISES

1. Introduction

The small macroeconomic model of Indonesia is developed for SEACEN training. The

objectives of this model is to facilitate the participants of the training to have understanding on

how the economy works, linkages among blocks, and especially linkages between monetary

and financial stability. This model can be used for policy exercises. Please note that in building

this model we concern only on direction, not on magnitude, of the coefficients (showing causal

relationship among variables). Please note also that this model can not be used for

forecasting.

The model consists of six blocks, i.e. Aggregate Demand, Aggregate Supply, Price,

Monetary, Financial, and External, as shown in Figure 1a. The complete picture of the model

is shown in Figure 1b. In the model, variables are classified into endogenous and exogenous.

Here policy variables (blue-colored) are assumed to be exogenous. The policy variables are

policy rate (BI rate), foreign exchange intervention, reserve requirement (RR), and loan-to-

value (LTV). Other exogenous variables, including the shocks, are yellow-colored. Meanwhile

there are two types of endogenous variables, i.e. one that is represented by behavioral

equation (green-colored) and one that is represented by identity equation (light blue-colored).

The model is built using MS Excel, in which there are eight sheets, i.e. “Dashboard”,

“GDP”, “Price, Exrate, Polrate”, “Monetary”, “Financial”, “External”, “BOP”, and “Notes”. This

FPP type model is a static model; it portrays year 2013 only. The model is so simple, yet can

clearly describe linkages among economic variables. As the MS Excel sheets are not

specifically designed to represent blocks, the sheets need to be mapped into blocks, as shown

in Table 1. Please note that some components of “Price, ExRate, PolRate” sheet are

dedicated to some different blocks, i.e. CPI and deflators for Price block; policy rate for

Monetary block, and exchange rate for External block.

The MS Excel sheets consist of some columns, which are basically divided into three

categories, i.e. actual data (2008 – 2013), model of “no feedback loop”, and model of “with

feedback loop”. In this model, feedback loop refers to loop from disrupted macroeconomic

balance (as implication of massive and persistent capital inflows) to reduced capital inflows

and pressures in the financial sector, that works through worsening macro risk perception. For

each category, the columns are divided into “no policy” and “with policy”. There are some

types of policy, i.e. “BI rate”, “BI rate + foreign exchange intervention”, “reserve requirement

(RR)”, “BI Rate + RR”, and “BI rate + RR + LTV”.

57

GDP

Potential Output Deflator

Price

CPI InflationOutput Gap

Aggregate Supply

Aggregate Demand

Consumption Investment Export Import

Financial External

Exchange

RateWorld GDPCreditRR

LTV

Monetary

Policy Rate

Broad Money

(M2)

Figure 1a Model Structure

Table 1 Mapping of Sheets into Blocks

No. Sheet Block

1 GDP Aggregate demand

2 GDP Aggregate supply

3 Price, ExRate, PolRate Price

4 Monetary

Monetary Price, ExRate, PolRate

5 Financial Financial

6

External

External BOP

Price, ExRate, PolRate

58

1

6a

6a

GDP

Consumption Investment Export Import

Potential Output

Disposable

Income

Real

Exchange

Rate

World GDP

Output Gap

Domestic

Demand

Import

Deflator

CPI Inflation

Export

Deflator

Nominal

Exchange

Rate

World CPI

RR

LTV

Bond Yield

Credit

Policy Rate

Stock Price

Housing

Price

Portfolio

Investment

Broad Money

(M2)

Net Domestic

Assets (NDA)

Net Foreign

Assets (NFA)Reserves

Claims on

Private

Sector

Forex

Intervention

6a

LIBOR

Direct

Investment

Other

Investment

Capital &

Financial

Account

Current

Account

CFA to GDP

Ratio

CA to GDP

Ratio

BOP Surplus/

Deficit

9

2a

2b

3a 2a3a

3b

4a

4a

4a

4b

4b

5a5b

6aCAR

9

99

Financial

Pressure

Index

Macro Risk

Perception

7

8

6b

6b

6b

7

7

Figure 1b Model Structure

Policy variable

Endogenous variable – behavioral equation

:

:

Endogenous variable – identity equation or formula

Exogenous variable

:

:

Capital inflows (portfolio investment)

Impact of capital inflows on reserves and exchange rate

Impact of capital inflows on reserves and NFA

Impact of real exchange rate on export-import

:

:

:

:

Impact of BOP surplus/deficit on credit

Impact of export-import on GDP (and its components)

Impact of domestic demand on import

Impact of GDP on output gap

:

:

:

:

Impact of GDP on financial indicators

Impact of output gap on CPI inflation:

:

Policy responses

:

:

1

2a

2b

3a

3b

4a

4b

5a

5b

6a

6b

9

Impact of MRP on capital inflows (feedback loop)

:

:

7

8

Impact of financial indicators on Financial Pressure Index (FPI)

Impact of CA to GDP ratio, CPI inflation, and FPI on Macro Risk Perception (MRP)

59

2. The Dashboard

The first sheet, called “Dashboard”, summarizes variables modelled in other sheets,

as shown in Table 2a, 2b, and 2c. In the Dashboard, the first column is names of the variables,

the second column indicates sequence of transmission. The next columns are values of the

variables in 2008 – 2013. The columns are divided into some categories, as explained above.

Information in the Dashboard is divided into some categories. At the top of the table

there are some policy variables, then followed with macroeconomic variables (GDP, CPI

inflation, exchange rate, Balance of Payment, and monetary aggregates), financial indicators

(credit growth, CAR, stock price, bond yield, and housing price, including Financial Pressure

Index (FPI)), and Macro Risk Perception (MRP, which is composite index of CPI inflation, FPI,

and CA to GDP ratio). At the bottom of the table there are information on types of shocks

(world GDP, LIBOR, and foreign direct investment).

We can change values of policy variables and some macroeconomic variables (e.g.

potential output, world economic growth, and world interest rate) in the Dashboard, as they

are exogenous. We can simulate the model and exercise some policies, either monetary

policy, macroprudential policy, or policy mix. By putting new value of policy variables, the

model will recalculate its equilibrium and the results will be shown in other parts of the

Dashboard. Meanwhile macroeconomic variables and financial indicators are linked to other

sheets. Please do not change the cells as they consists of formulas. On the other hand, we

can also simulate the model by putting different values of shocks.

60

Table 2a The Dashboard – Actual

Policy VariablesPolicy Rate (BI Rate, %) 9 6.50 6.50 5.75 6.63

Reserve Requirement (RR, %) 9 8.00 10.50 11.50 11.50

Loan To Value (LTV, %) 9 85.00 85.00 72.50 72.50

Forex Intervention (in millions USD) 9 0 0 0 0

Macroeconomic Variables

GDP (%)

Consumption expenditures 4a 4.14 4.51 4.77 5.23

Gross domestic capital formation 4a 8.48 8.77 9.25 4.71

Domestic Demand 4a 5.35 6.13 7.88 5.12

Export of goods and services 3a 15.27 13.65 2.00 5.30

Import of goods and services (-/-) 3a, 4b 17.34 13.34 6.66 1.21

Gross Domestic Product 4a 6.22 6.49 6.26 5.78

Potential Output 5.52 5.74 5.67 5.64

Output Gap 5a -0.97 -0.27 -0.35 0.42

CPI Inflation (%) 5b 6.96 3.79 4.30 8.38

Exchange Rate (%)

Nominal Exchange Rate (appr.(-)/depr.(+)) -12.48 -3.53 6.80 11.66

Real Exchange Rate (appr.(-)/depr.(+)) -17.19 -4.27 4.05 4.88

Balance of Payment

Current Account (CA, in millions USD) 5,144 1,685 -24,418 -28,450

Capital & Financial Account (CF, in millions USD) 1, 8 26,620 13,567 24,896 22,731

Overall Balance (in millions USD) 30,285 11,857 215 -7,325

CA to GDP (%) 0.72 0.20 -2.78 -3.27

CFA to GDP (%) 3.75 1.60 2.84 2.61

Monetary Aggregates

Broad Money (M2, in trillions Rp) 2,471 2,877 3,308 3,728

Net Foreign Assets (in trillions Rp) 2b 865 912 965 1,011

Net Domestic Assets (in trillions Rp) 1,606 1,965 2,342 2,716

Financial IndicatorsCredit Growth (%) 3b, 6a 14.82 20.05 18.01 12.20

Capital Adequacy Ratio (CAR, %) 6a 17.55 17.18 17.72 18.56

Bond Yield (10 y, %) 8.47 7.40 5.85 6.89

Stock Price (index) 6a 3,095 3,746 4,119 4,606

Housing Price (index) 6a 100.00 115.14 127.65 140.91

Financial Pressure Index (FPI) 6b 100.00 82.77 94.61 110.10

Macro Risk Perception 7 100.00 85.56 107.74 131.82

External Variables

World GDP (%) 4.10 3.50 3.09 3.00

LIBOR (3 months, %) 0.34 0.35 0.32 0.27

2a

20132012VariablesSequence of

transmission2010 2011

61

Table 2b The Dashboard – No Feedback Loop

Policy VariablesPolicy Rate (BI Rate, %) 9 6.50 6.50 5.75 0.00 0.00 0.00 0.00 0.00 0.00 6.63

Reserve Requirement (RR, %) 9 8.00 10.50 11.50 0.00 0.00 0.00 0.00 0.00 0.00 11.50

Loan To Value (LTV, %) 9 85.00 85.00 72.50 0.00 0.00 0.00 0.00 0.00 0.00 72.50

Forex Intervention (in millions USD) 9 0 0 0 0 0 0 0 0 0 0

Macroeconomic Variables

GDP (%)

Consumption expenditures 4a 4.14 4.51 4.77 6.72 6.72 6.72 6.72 6.72 6.72 5.23

Gross domestic capital formation 4a 8.48 8.77 9.25 8.46 8.46 8.46 8.46 8.46 8.46 4.71

Domestic Demand 4a 5.35 6.13 7.88 7.21 7.21 7.21 7.21 7.21 7.21 5.12

Export of goods and services 3a 15.27 13.65 2.00 4.58 4.58 4.58 4.58 4.58 4.58 5.30

Import of goods and services (-/-) 3a, 4b 17.34 13.34 6.66 8.83 8.83 8.83 8.83 8.83 8.83 1.21

Gross Domestic Product 4a 6.22 6.49 6.26 4.39 4.39 4.39 4.39 4.39 4.39 5.78

Potential Output 5.52 5.74 5.67 0.00 0.00 0.00 0.00 0.00 0.00 5.64

Output Gap 5a -0.97 -0.27 -0.35 4.69 4.69 4.69 4.69 4.69 4.69 0.42

CPI Inflation (%) 5b 6.96 3.79 4.30 18.33 18.33 18.33 18.33 18.33 18.33 8.38

Exchange Rate (%)

Nominal Exchange Rate (appr.(-)/depr.(+)) -12.48 -3.53 6.80 23.88 23.88 23.88 23.88 23.88 23.88 11.66

Real Exchange Rate (appr.(-)/depr.(+)) -17.19 -4.27 4.05 6.57 6.57 6.57 6.57 6.57 6.57 4.88

Balance of Payment

Current Account (CA, in millions USD) 5,144 1,685 -24,418 -28,602 -28,602 -28,602 -28,602 -28,602 -28,602 -28,450

Capital & Financial Account (CF, in millions USD) 1, 8 26,620 13,567 24,896 24,568 24,568 24,568 24,568 24,568 24,568 22,731

Overall Balance (in millions USD) 30,285 11,857 215 -5,639 -5,639 -5,639 -5,639 -5,639 -5,639 -7,325

CA to GDP (%) 0.72 0.20 -2.78 -3.67 -3.67 -3.67 -3.67 -3.67 -3.67 -3.27

CFA to GDP (%) 3.75 1.60 2.84 3.16 3.16 3.16 3.16 3.16 3.16 2.61

Monetary Aggregates

Broad Money (M2, in trillions Rp) 2,471 2,877 3,308 4,058 4,058 4,058 4,058 4,058 4,058 3,728

Net Foreign Assets (in trillions Rp) 2b 865 912 965 1,242 1,242 1,242 1,242 1,242 1,242 1,011

Net Domestic Assets (in trillions Rp) 1,606 1,965 2,342 2,815 2,815 2,815 2,815 2,815 2,815 2,716

Financial IndicatorsCredit Growth (%) 3b, 6a 14.82 20.05 18.01 5.99 5.99 5.99 5.99 5.99 5.99 12.20

Capital Adequacy Ratio (CAR, %) 6a 17.55 17.18 17.72 16.26 16.26 16.26 16.26 16.26 16.26 18.56

Bond Yield (10 y, %) 8.47 7.40 5.85 3.01 3.01 3.01 3.01 3.01 3.01 6.89

Stock Price (index) 6a 3,095 3,746 4,119 4,688 4,688 4,688 4,688 4,688 4,688 4,606

Housing Price (index) 6a 100.00 115.14 127.65 137.94 137.94 137.94 137.94 137.94 137.94 140.91

Financial Pressure Index (FPI) 6b 100.00 82.77 94.61 146.16 146.16 146.16 146.16 146.16 146.16 110.10

Macro Risk Perception 7 100.00 85.56 107.74 185.66 185.66 185.66 185.66 185.66 185.66 131.82

External Variables

World GDP (%) 4.10 3.50 3.09 0.00 0.00 0.00 0.00 0.00 0.00 3.00

LIBOR (3 months, %) 0.34 0.35 0.32 0.00 0.00 0.00 0.00 0.00 0.00 0.27

2a

BI Rate +

Fx Intv.RR

BI Rate +

RR

BI Rate +

RR +

LTV

2012

2013

No Feedback Loop

ActualNo Policy

With Policy

BI Rate

VariablesSequence of

transmission2010 2011

62

Table 2c The Dashboard – With Feedback Loop

Policy VariablesPolicy Rate (BI Rate, %) 9 6.50 6.50 5.75 0.00 0.00 0.00 0.00 0.00 0.00 6.63

Reserve Requirement (RR, %) 9 8.00 10.50 11.50 0.00 0.00 0.00 0.00 0.00 0.00 11.50

Loan To Value (LTV, %) 9 85.00 85.00 72.50 0.00 0.00 0.00 0.00 0.00 0.00 72.50

Forex Intervention (in millions USD) 9 0 0 0 0 0 0 0 0 0 0

Macroeconomic Variables

GDP (%)

Consumption expenditures 4a 4.14 4.51 4.77 6.56 6.56 6.56 6.56 6.56 6.56 5.23

Gross domestic capital formation 4a 8.48 8.77 9.25 6.49 6.49 6.49 6.49 6.49 6.49 4.71

Domestic Demand 4a 5.35 6.13 7.88 6.54 6.54 6.54 6.54 6.54 6.54 5.12

Export of goods and services 3a 15.27 13.65 2.00 4.81 4.81 4.81 4.81 4.81 4.81 5.30

Import of goods and services (-/-) 3a, 4b 17.34 13.34 6.66 8.03 8.03 8.03 8.03 8.03 8.03 1.21

Gross Domestic Product 4a 6.22 6.49 6.26 4.21 4.21 4.21 4.21 4.21 4.21 5.78

Potential Output 5.52 5.74 5.67 0.00 0.00 0.00 0.00 0.00 0.00 5.64

Output Gap 5a -0.97 -0.27 -0.35 4.51 4.51 4.51 4.51 4.51 4.51 0.42

CPI Inflation (%) 5b 6.96 3.79 4.30 21.26 21.26 21.26 21.26 21.26 21.26 8.38

Exchange Rate (%)

Nominal Exchange Rate (appr.(-)/depr.(+)) -12.48 -3.53 6.80 32.68 32.68 32.68 32.68 32.68 32.68 11.66

Real Exchange Rate (appr.(-)/depr.(+)) -17.19 -4.27 4.05 11.38 11.38 11.38 11.38 11.38 11.38 4.88

Balance of Payment

Current Account (CA, in millions USD) 5,144 1,685 -24,418 -28,633 -28,633 -28,633 -28,633 -28,633 -28,633 -28,450

Capital & Financial Account (CF, in millions USD) 1, 8 26,620 13,567 24,896 18,674 18,674 18,674 18,674 18,674 18,674 22,731

Overall Balance (in millions USD) 30,285 11,857 215 -11,563 -11,563 -11,563 -11,563 -11,563 -11,563 -7,325

CA to GDP (%) 0.72 0.20 -2.78 -3.98 -3.98 -3.98 -3.98 -3.98 -3.98 -3.27

CFA to GDP (%) 3.75 1.60 2.84 2.59 2.59 2.59 2.59 2.59 2.59 2.61

Monetary Aggregates

Broad Money (M2, in trillions Rp) 2,471 2,877 3,308 3,860 3,860 3,860 3,860 3,860 3,860 3,728

Net Foreign Assets (in trillions Rp) 2b 865 912 965 1,257 1,257 1,257 1,257 1,257 1,257 1,011

Net Domestic Assets (in trillions Rp) 1,606 1,965 2,342 2,603 2,603 2,603 2,603 2,603 2,603 2,716

Financial IndicatorsCredit Growth (%) 3b, 6a 14.82 20.05 18.01 -3.05 -3.05 -3.05 -3.05 -3.05 -3.05 12.20

Capital Adequacy Ratio (CAR, %) 6a 17.55 17.18 17.72 17.30 17.30 17.30 17.30 17.30 17.30 18.56

Bond Yield (10 y, %) 8.47 7.40 5.85 4.19 4.19 4.19 4.19 4.19 4.19 6.89

Stock Price (index) 6a 3,095 3,746 4,119 4,087 4,087 4,087 4,087 4,087 4,087 4,606

Housing Price (index) 6a 100.00 115.14 127.65 136.57 136.57 136.57 136.57 136.57 136.57 140.91

Financial Pressure Index (FPI) 6b 100.00 82.77 94.61 148.78 148.78 148.78 148.78 148.78 148.78 110.10

Macro Risk Perception 7 100.00 85.56 107.74 201.00 201.00 201.00 201.00 201.00 201.00 131.82

External Variables

World GDP (%) 4.10 3.50 3.09 0.00 0.00 0.00 0.00 0.00 0.00 3.00

LIBOR (3 months, %) 0.34 0.35 0.32 0.00 0.00 0.00 0.00 0.00 0.00 0.27

2a

2012

2013

With Feedback Loop

ActualNo Policy

With PolicyVariablesSequence of

transmission2010 2011

RRBI Rate +

RR

BI Rate +

RR +

LTV

BI RateBI Rate +

Fx Intv.

63

3. Aggregate Demand – Aggregate Supply

In the Aggregate Demand (AD) block, there are four types of expenditure, i.e. consumption,

investment, export, and import, as shown in Figure 2. Consumption is affected by disposable income,

while investment is affected by GDP, credit, and real interest rate (policy rate minus expected inflation,

herewith proxied by CPI inflation). Export is affected by world GDP and real exchange rate, whereas

import is affected by domestic demand, real exchange rate, and export.

Meanwhile Aggregate Supply (AS) block is represented by potential output. Here the value of

potential output is generated by Hodrick-Prescott (HP) filter. Difference between GDP and potential

output (called output gap) shows by how much GDP exceed output produced by Indonesian economy

at ‘full capacity’. It is a non-accelerating inflation rate of capacity utilization (NAICU). The output gap

represents level of inflation pressure.

In the model, GDP is presented both in constant and current price, and also its growth, as

shown in Table 3a, 3b, and 3c. Its components are presented, including some details which is not our

concern, such as statistical discrepancy, net factor income from abroad, net indirect taxes, and

depreciation. In the model, they are either exogenous or emptied.

CPI Inflation

GDP

Consumption Investment Export Import

Potential Output

CreditDisposable

IncomePolicy Rate

Exchange

RateWorld GDP

Output Gap

Change in

Inventory

Domestic

Demand

Figure 2 Aggregate Demand-Aggregate Supply Block

64

Table 3a GDP – Actual

In billion Rupiah (constant price)

Consumption expenditures 1,360,488 1,444,904 1,504,742 1,572,637 1,647,579 1,733,787

Household Final Consumption 1,191,191 1,249,069 1,308,273 1,369,881 1,442,193 1,518,394

Government Final Consumption 169,297 195,835 196,469 202,756 205,386 215,394

Gross domestic capital formation 493,822 510,087 553,348 601,891 657,588 688,559

Change in inventories 2,170 -2,065 -604 9,033 50,371 53,768

Statistical Discrepancy 27,040 2,205 13,823 2,184 22,732 -336

Export of goods and services 1,032,278 932,249 1,074,569 1,221,229 1,245,703 1,311,760

Import of goods and services (-/-) 833,342 708,529 831,418 942,297 1,005,037 1,017,191

Gross Domestic Product 2,082,456 2,178,851 2,314,459 2,464,677 2,618,938 2,770,345

Net factor income from abroad -96,596 -109,819 -92,992 -96,459 -100,656 -111,056

Gross National Product 1,985,861 2,069,031 2,221,467 2,368,218 2,518,282 2,659,289

Net indirect taxes (-/-) 45,382 83,421 81,054 42,980 15,272 82,628

Depreciation (-/-) 104,123 108,943 115,723 123,234 130,947 138,517

National Income 1,836,356 1,876,667 2,024,690 2,202,004 2,372,064 2,438,145

Domestic Demand 1,856,481 1,952,926 2,057,485 2,183,561 2,355,538 2,476,114

Potential Output 2,101,410 2,214,886 2,337,148 2,471,300 2,611,423 2,758,809

Output Gap (%) -0.90 -1.63 -0.97 -0.27 -0.35 0.42

In billion Rupiah (current price)

Consumption expenditures 3,416,824 3,828,585 4,230,708 4,721,946 5,229,643 5,898,336

Household Final Consumption 2,999,957 3,290,996 3,643,425 4,053,363 4,496,374 5,071,095

Government Final Consumption 416,867 537,588 587,283 668,582 733,269 827,242

Gross domestic capital formation 1,370,717 1,744,357 2,064,994 2,372,765 2,688,883 2,876,253

Change in inventories 5,822 -7,264 18,364 70,775 170,309 179,778

Statistical Discrepancy 103,109 -116,791 24,732 152,544 269,075 310,914

Export of goods and services 1,475,119 1,354,410 1,584,674 1,955,821 1,999,255 2,156,809

Import of goods and services (-/-) 1,422,902 1,197,093 1,476,620 1,851,071 2,127,725 2,338,119

Gross Domestic Product 4,948,688 5,606,203 6,446,852 7,422,781 8,229,440 9,083,973

Net factor income from abroad -175,865 -196,220 -180,969 -211,690 -243,192 -281,097

Gross National Product 4,772,823 5,409,984 6,265,883 7,211,092 7,986,247 8,802,876

Net indirect taxes (-/-) 104,045 214,834 387,109 453,151 388,779 600,641

Depreciation (-/-) 247,434 280,310 322,343 371,140 411,472 454,198

National Income 4,421,344 4,914,841 5,718,347 6,660,227 7,528,338 8,077,565

Domestic Demand 4,793,363 5,565,678 6,314,066 7,165,486 8,088,835 8,954,367

Gross Domestic Product (in million USD, nominal) 512,679 543,314 709,994 845,821 876,878 870,902

Growth (%, constant price)

Consumption expenditures 5.94 6.20 4.14 4.51 4.77 5.23

Household Final Consumption 5.34 4.86 4.74 4.71 5.28 5.28

Government Final Consumption 10.43 15.68 0.32 3.20 1.30 4.87

Gross domestic capital formation 11.89 3.29 8.48 8.77 9.25 4.71

Change in inventories -992.95 -195.14 -70.73 -1,594.67 457.60 6.74

Statistical Discrepancy -50.10 -91.85 526.92 -84.20 940.86 -101.48

Export of goods and services 9.53 -9.69 15.27 13.65 2.00 5.30

Import of goods and services (-/-) 10.00 -14.98 17.34 13.34 6.66 1.21

Gross Domestic Product 6.01 4.63 6.22 6.49 6.26 5.78

Net factor income from abroad -19.88 13.69 -15.32 3.73 4.35 10.33

Gross National Product 7.71 4.19 7.37 6.61 6.34 5.60

Net indirect taxes (-/-) -19.53 83.82 -2.84 -46.97 -64.47 441.04

Depreciation (-/-) 6.01 4.63 6.22 6.49 6.26 5.78

National Income 8.71 2.20 7.89 8.76 7.72 2.79

Domestic Demand 7.46 5.20 5.35 6.13 7.88 5.12

20132012Type of Expenditures 2008 2009 2010 2011

65

Table 3b GDP – No Feedback Loop

In billion Rupiah (constant price)

Consumption expenditures 1,758,285 1,758,285 1,758,285 1,758,285 1,758,285 1,758,285 1,733,787

Household Final Consumption 1,518,394

Government Final Consumption 215,394

Gross domestic capital formation 713,244 713,244 713,244 713,244 713,244 713,244 688,559

Change in inventories 53,768 53,768 53,768 53,768 53,768 53,768 53,768

Statistical Discrepancy -336 -336 -336 -336 -336 -336 -336

Export of goods and services 1,302,698 1,302,698 1,302,698 1,302,698 1,302,698 1,302,698 1,311,760

Import of goods and services (-/-) 1,093,826 1,093,826 1,093,826 1,093,826 1,093,826 1,093,826 1,017,191

Gross Domestic Product 2,733,833 2,733,833 2,733,833 2,733,833 2,733,833 2,733,833 2,770,345

Net factor income from abroad -111,056

Gross National Product 2,659,289

Net indirect taxes (-/-) 82,628

Depreciation (-/-) 138,517

National Income 2,438,145

Domestic Demand 2,525,297 2,525,297 2,525,297 2,525,297 2,525,297 2,525,297 2,476,114

Potential Output 2,611,423 2,611,423 2,611,423 2,611,423 2,611,423 2,611,423 2,758,809

Output Gap (%) 4.69 4.69 4.69 4.69 4.69 4.69 0.42

In billion Rupiah (current price)

Consumption expenditures 5,981,677 5,981,677 5,981,677 5,981,677 5,981,677 5,981,677 5,898,336

Household Final Consumption 5,071,095

Government Final Consumption 827,242

Gross domestic capital formation 2,979,368 2,979,368 2,979,368 2,979,368 2,979,368 2,979,368 2,876,253

Change in inventories 224,600 224,600 224,600 224,600 224,600 224,600 179,778

Statistical Discrepancy 310,914 310,914 310,914 310,914 310,914 310,914 310,914

Export of goods and services 2,410,530 2,410,530 2,410,530 2,410,530 2,410,530 2,410,530 2,156,809

Import of goods and services (-/-) 2,879,087 2,879,087 2,879,087 2,879,087 2,879,087 2,879,087 2,338,119

Gross Domestic Product 9,028,002 9,028,002 9,028,002 9,028,002 9,028,002 9,028,002 9,083,973

Net factor income from abroad -281,097

Gross National Product 8,802,876

Net indirect taxes (-/-) 600,641

Depreciation (-/-) 454,198

National Income 8,077,565

Domestic Demand 9,185,645 9,185,645 9,185,645 9,185,645 9,185,645 9,185,645 8,954,367

Gross Domestic Product (in million USD, nominal) 778,529 778,529 778,529 778,529 778,529 778,529 870,902

Growth (%, constant price)

Consumption expenditures 6.72 6.72 6.72 6.72 6.72 6.72 5.23

Household Final Consumption 5.28

Government Final Consumption 4.87

Gross domestic capital formation 8.46 8.46 8.46 8.46 8.46 8.46 4.71

Change in inventories 6.74 6.74 6.74 6.74 6.74 6.74 6.74

Statistical Discrepancy -101.48 -101.48 -101.48 -101.48 -101.48 -101.48 -101.48

Export of goods and services 4.58 4.58 4.58 4.58 4.58 4.58 5.30

Import of goods and services (-/-) 8.83 8.83 8.83 8.83 8.83 8.83 1.21

Gross Domestic Product 4.39 4.39 4.39 4.39 4.39 4.39 5.78

Net factor income from abroad 10.33

Gross National Product 5.60

Net indirect taxes (-/-) 441.04

Depreciation (-/-) 5.78

National Income 2.79

Domestic Demand 7.21 7.21 7.21 7.21 7.21 7.21 5.12

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.RR

BI Rate +

RR

BI Rate +

RR + LTV

Type of Expenditures

66

Table 3c GDP – With Feedback Loop

In billion Rupiah (constant price)

Consumption expenditures 1,755,643 1,755,643 1,755,643 1,755,643 1,755,643 1,755,643 1,733,787

Household Final Consumption 1,518,394

Government Final Consumption 215,394

Gross domestic capital formation 700,244 700,244 700,244 700,244 700,244 700,244 688,559

Change in inventories 53,768 53,768 53,768 53,768 53,768 53,768 53,768

Statistical Discrepancy -336 -336 -336 -336 -336 -336 -336

Export of goods and services 1,305,640 1,305,640 1,305,640 1,305,640 1,305,640 1,305,640 1,311,760

Import of goods and services (-/-) 1,085,761 1,085,761 1,085,761 1,085,761 1,085,761 1,085,761 1,017,191

Gross Domestic Product 2,729,198 2,729,198 2,729,198 2,729,198 2,729,198 2,729,198 2,770,345

Net factor income from abroad -111,056

Gross National Product 2,659,289

Net indirect taxes (-/-) 82,628

Depreciation (-/-) 138,517

National Income 2,438,145

Domestic Demand 2,509,655 2,509,655 2,509,655 2,509,655 2,509,655 2,509,655 2,476,114

Potential Output 2,611,423 2,611,423 2,611,423 2,611,423 2,611,423 2,611,423 2,758,809

Output Gap (%) 4.51 4.51 4.51 4.51 4.51 4.51 0.42

In billion Rupiah (current price)

Consumption expenditures 5,972,690 5,972,690 5,972,690 5,972,690 5,972,690 5,972,690 5,898,336

Household Final Consumption 5,071,095

Government Final Consumption 827,242

Gross domestic capital formation 2,925,062 2,925,062 2,925,062 2,925,062 2,925,062 2,925,062 2,876,253

Change in inventories 224,600 224,600 224,600 224,600 224,600 224,600 179,778

Statistical Discrepancy 310,914 310,914 310,914 310,914 310,914 310,914 310,914

Export of goods and services 2,611,265 2,611,265 2,611,265 2,611,265 2,611,265 2,611,265 2,156,809

Import of goods and services (-/-) 3,106,238 3,106,238 3,106,238 3,106,238 3,106,238 3,106,238 2,338,119

Gross Domestic Product 8,938,293 8,938,293 8,938,293 8,938,293 8,938,293 8,938,293 9,083,973

Net factor income from abroad -281,097

Gross National Product 8,802,876

Net indirect taxes (-/-) 600,641

Depreciation (-/-) 454,198

National Income 8,077,565

Domestic Demand 9,122,352 9,122,352 9,122,352 9,122,352 9,122,352 9,122,352 8,954,367

Gross Domestic Product (in million USD, nominal) 719,679 719,679 719,679 719,679 719,679 719,679 870,902

Growth (%, constant price)

Consumption expenditures 6.56 6.56 6.56 6.56 6.56 6.56 5.23

Household Final Consumption 5.28

Government Final Consumption 4.87

Gross domestic capital formation 6.49 6.49 6.49 6.49 6.49 6.49 4.71

Change in inventories 6.74 6.74 6.74 6.74 6.74 6.74 6.74

Statistical Discrepancy -101.48 -101.48 -101.48 -101.48 -101.48 -101.48 -101.48

Export of goods and services 4.81 4.81 4.81 4.81 4.81 4.81 5.30

Import of goods and services (-/-) 8.03 8.03 8.03 8.03 8.03 8.03 1.21

Gross Domestic Product 4.21 4.21 4.21 4.21 4.21 4.21 5.78

Net factor income from abroad 10.33

Gross National Product 5.60

Net indirect taxes (-/-) 441.04

Depreciation (-/-) 5.78

National Income 2.79

Domestic Demand 6.54 6.54 6.54 6.54 6.54 6.54 5.12

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With Policy

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

Type of Expenditures

67

4. Price

Price block consists of CPI inflation and some deflators, i.e. consumption deflator,

investment deflator, export deflator, and import deflator, as shown in Figure 3 and Table 4a,

4b, and 4c. CPI inflation is affected by its lag (backward looking), output gap and import

deflator (which represents direct pass-through of exchange rate). Here for simplicity reason,

impact of expectation on inflation is not modelled. Actually, expectation could significantly

affects inflation. Monetary stability is represented by dynamics of CPI inflation.

Meanwhile export and import deflator are affected by their lags and nominal exchange

rate. On the other hand, consumption and investment deflator is affected by CPI inflation. The

deflators are basically used to calculate nominal values from real values, mainly components

of GDP. In the model, components of GDP (aggregate demand) in constant price (real values)

are modelled by behavioral equations, whereas their current price (nominal values) are

modelled by identity equations. For simplicity, in this model consumption and investment

deflator are set as exogenous variables.

GDP

Potential Output

Import

Deflator

CPI InflationOutput Gap

Consumption

Deflator

Investment

Deflator

Export

Deflator

Nominal

Exchange

Rate

Real

Exchange

Rate

World CPI

Figure 3 Price Block

68

Table 4a Price and Deflator – Actual

Table 4b Price and Deflator – No Feedback Loop

Table 4c Price and Deflator – With Feedback Loop

Price

CPI 113.86 117.03 125.17 129.91 135.49 146.84

CPI Inflation 11.06 2.78 6.96 3.79 4.30 8.38

Deflator

Consumption Deflator 251.15 264.97 281.16 300.26 317.41 340.20

Investment Deflator 277.57 341.97 373.18 394.22 408.90 417.72

Export Deflator 142.90 145.28 147.47 160.15 160.49 164.42

Import Deflator 170.75 168.95 177.60 196.44 211.71 229.86

20132012Items 2008 2009 2010 2011

Price

CPI 160.33 160.33 160.33 160.33 160.33 160.33 146.84

CPI Inflation 18.33 18.33 18.33 18.33 18.33 18.33 8.38

Deflator

Consumption Deflator 340.20 340.20 340.20 340.20 340.20 340.20 340.20

Investment Deflator 417.72 417.72 417.72 417.72 417.72 417.72 417.72

Export Deflator 185.04 185.04 185.04 185.04 185.04 185.04 164.42

Import Deflator 263.21 263.21 263.21 263.21 263.21 263.21 229.86

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.RR

BI Rate +

RR

BI Rate +

RR + LTV

Items

Price

CPI 164.29 164.29 164.29 164.29 164.29 164.29 146.84

CPI Inflation 21.26 21.26 21.26 21.26 21.26 21.26 8.38

Deflator

Consumption Deflator 340.20 340.20 340.20 340.20 340.20 340.20 340.20

Investment Deflator 417.72 417.72 417.72 417.72 417.72 417.72 417.72

Export Deflator 200.00 200.00 200.00 200.00 200.00 200.00 164.42

Import Deflator 286.09 286.09 286.09 286.09 286.09 286.09 229.86

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With Policy

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

Items

69

5. Monetary

In this model, what usually called Monetary block is divided into Monetary block and

Financial block. Monetary block consists of monetary aggregates, i.e. Net Domestic Assets

(NDA) and Net Foreign Assets (NFA), as shown in Figure 4. They are endogenous variables;

their values are generated from identity equations. Credit, which belongs to Financial block,

contributes to NDA. On the other hand, some components of External block, i.e. export, import,

and portfolio investment, contributes to reserves (in USD). The reserves then multiplied by

nominal exchange rate of Rupiah to produce NFA.

In the model, monetary aggregates are presented in two ways, i.e. components of

broad money (M2) and factors affecting broad money, as shown in Table 5a, 6a, and 7a. Its

components are presented, including some details which is not our concern, such as narrow

money (M1), quasy money, securities other than shares, and some components of NDA and

NFA. In the model, they are either exogenous or emptied. Beside the monetary aggregates,

in this block there is policy rate (BI rate), as shown in Table 5b, 6b, and 7b.

Nominal

Exchange

Rate

Broad Money

(M2)

Net Domestic

Assets (NDA)

Net Foreign

Assets (NFA)

Net Claims

on Central

Government

Claims on

Other Sector

Deposits and Securities Other than

Shares

Liabilities to Other

Financial Corporation

Shares and

Other Equity

Net Other

Items

Claims on

Private

Sector

Claims on

Other

Financial

Claims on

State and

Local Gov.

Claims on Public Non Financial

Corp.

Reserves

Credit

Export

Import

Portfolio

Investment

Figure 4 Monetary Block

70

Table 5a Monetary – Actual

Table 5b Policy Rate – Actual

In billion Rupiah

Broad Money (M2) 1,895,839 2,141,384 2,471,206 2,877,220 3,307,577 3,727,696

Narrow Money (M1) 456,787 515,824 605,411 722,991 841,722 887,064

Quasi Money 1,435,772 1,622,055 1,856,720 2,139,840 2,455,435 2,817,826

Time Deposits 819,791 894,280 1,003,054 1,121,962 1,245,869 1,423,709

Savings Deposits 503,080 603,320 714,487 864,557 1,027,226 1,151,702

Foreign Currency Demand Deposits 112,901 124,455 139,180 153,320 182,341 242,416

Securities Other Than Shares 3,279 3,504 9,075 14,388 10,420 22,805

Factors Affecting Broad Money 1,895,839 2,141,384 2,471,206 2,877,220 3,307,577 3,727,696

Net Foreign Assets 593,137 679,448 865,121 912,174 965,442 1,011,361

Claims on Non_Residents 715,261 811,045 1,033,086 1,134,951 1,270,701 1,442,897

Liabilities to Non_Residents 122,124 131,597 167,964 222,777 305,259 431,536

Net Domestic Assets 1,302,702 1,461,936 1,606,084 1,965,045 2,342,135 2,716,334

Net Claims on Central Goverment 387,248 429,406 368,717 351,177 389,827 406,612

Claims on Other Sector 1,413,247 1,538,918 1,910,022 2,383,823 2,917,452 3,525,435

Claims on Other Financial 50,265 67,625 124,852 161,444 174,952 217,469

Claims on State and Local Govermment 984 1,017 1,594 1,410 2,790 4,726

Claims on Public Non_Financial Corp. 47,949 66,589 99,369 102,594 158,383 206,109

Claims on Private Sectors 1,314,049 1,403,686 1,684,207 2,118,376 2,581,327 3,097,131

Deposits and Securities Other Than Shares Excluded Broad Money-17,556 -23,625 -113,547 -186,990 -242,014 -279,580

Liabilities to Other Financial Corporation -7,107 -8,810 -19,194 -27,221 -34,333 -47,948

Shares and Other Equity -374,986 -354,660 -418,454 -525,849 -706,644 -920,172

Net Other Items -98,144 -119,293 -121,460 -29,895 17,848 31,986

20132012Items 2008 2009 2010 2011

Policy Rate

BI Rate 8.75 6.94 6.50 6.56 5.75 6.63

2013Items 2008 2009 2010 2011 2012

71

Table 6a Monetary – No Feedback Loop

Table 6b Policy Rate – No Feedback Loop

In billion Rupiah

Broad Money (M2) 4,057,862 4,057,862 4,057,862 4,057,862 4,057,862 4,057,862 3,727,696

Narrow Money (M1) 887,064

Quasi Money 2,817,826

Time Deposits 1,423,709

Savings Deposits 1,151,702

Foreign Currency Demand Deposits 242,416

Securities Other Than Shares 22,805

Factors Affecting Broad Money 4,057,862 4,057,862 4,057,862 4,057,862 4,057,862 4,057,862 3,727,696

Net Foreign Assets 1,242,447 1,242,447 1,242,447 1,242,447 1,242,447 1,242,447 1,011,361

Claims on Non_Residents 1,442,897

Liabilities to Non_Residents 431,536

Net Domestic Assets 2,815,414 2,815,414 2,815,414 2,815,414 2,815,414 2,815,414 2,716,334

Net Claims on Central Goverment 406,612 406,612 406,612 406,612 406,612 406,612 406,612

Claims on Other Sector 3,624,516 3,624,516 3,624,516 3,624,516 3,624,516 3,624,516 3,525,435

Claims on Other Financial 217,469 217,469 217,469 217,469 217,469 217,469 217,469

Claims on State and Local Govermment 4,726 4,726 4,726 4,726 4,726 4,726 4,726

Claims on Public Non_Financial Corp. 206,109 206,109 206,109 206,109 206,109 206,109 206,109

Claims on Private Sectors 3,196,211 3,196,211 3,196,211 3,196,211 3,196,211 3,196,211 3,097,131

Deposits and Securities Other Than Shares Excluded Broad Money-279,580 -279,580 -279,580 -279,580 -279,580 -279,580 -279,580

Liabilities to Other Financial Corporation -47,948 -47,948 -47,948 -47,948 -47,948 -47,948 -47,948

Shares and Other Equity -920,172 -920,172 -920,172 -920,172 -920,172 -920,172 -920,172

Net Other Items 31,986 31,986 31,986 31,986 31,986 31,986 31,986

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.RR

BI Rate +

RR

BI Rate +

RR + LTV

Items

Policy Rate

BI Rate 0.00 0.00 0.00 0.00 0.00 0.00 6.63

RRBI Rate +

RR

BI Rate +

RR + LTV

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.

Items

72

Table 7a Monetary – With Feedback Loop

Table 7b Policy Rate – With Feedback Loop

In billion Rupiah

Broad Money (M2) 3,859,695 3,859,695 3,859,695 3,859,695 3,859,695 3,859,695 3,727,696

Narrow Money (M1) 887,064

Quasi Money 2,817,826

Time Deposits 1,423,709

Savings Deposits 1,151,702

Foreign Currency Demand Deposits 242,416

Securities Other Than Shares 22,805

Factors Affecting Broad Money 3,859,695 3,859,695 3,859,695 3,859,695 3,859,695 3,859,695 3,727,696

Net Foreign Assets 1,257,109 1,257,109 1,257,109 1,257,109 1,257,109 1,257,109 1,011,361

Claims on Non_Residents 1,442,897

Liabilities to Non_Residents 431,536

Net Domestic Assets 2,602,586 2,602,586 2,602,586 2,602,586 2,602,586 2,602,586 2,716,334

Net Claims on Central Goverment 406,612 406,612 406,612 406,612 406,612 406,612 406,612

Claims on Other Sector 3,411,687 3,411,687 3,411,687 3,411,687 3,411,687 3,411,687 3,525,435

Claims on Other Financial 217,469 217,469 217,469 217,469 217,469 217,469 217,469

Claims on State and Local Govermment 4,726 4,726 4,726 4,726 4,726 4,726 4,726

Claims on Public Non_Financial Corp. 206,109 206,109 206,109 206,109 206,109 206,109 206,109

Claims on Private Sectors 2,983,383 2,983,383 2,983,383 2,983,383 2,983,383 2,983,383 3,097,131

Deposits and Securities Other Than Shares Excluded Broad Money-279,580 -279,580 -279,580 -279,580 -279,580 -279,580 -279,580

Liabilities to Other Financial Corporation -47,948 -47,948 -47,948 -47,948 -47,948 -47,948 -47,948

Shares and Other Equity -920,172 -920,172 -920,172 -920,172 -920,172 -920,172 -920,172

Net Other Items 31,986 31,986 31,986 31,986 31,986 31,986 31,986

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With Policy

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

Items

Policy Rate

BI Rate 0.00 0.00 0.00 0.00 0.00 0.00 6.63

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

BI Rate + Fx

Intv.RR

With Feedback Loop

ActualNo Policy

With PolicyItems

73

6. Financial

In this model, there are some financial indicators that we concern about, i.e. credit

growth, Capital Adequacy Ratio (CAR), stock price, bond yield, and housing price, including

Financial Pressure Index), as shown in Figure 5 and Table 8a, 8b, and 8c. Credit is affected

by its lag, GDP, real policy rate, BOP surplus/deficit, and also by macroprudential policy such

as reserve requirement (RR) and loan-to-value (LTV). CAR is affected by its lag, credit growth,

and default risk (which is proxied by GDP growth). In this model, bond yield is affected by its

lag and policy rate. Meanwhile stock price is affected by its lag, GDP growth (which represents

economic condition), and portfolio investment (multiplied with nominal exchange rate). On the

other hand, housing price is affected by GDP, which represents level of demand.

There are two composite index in this block. The first one is Financial Pressure Index

(FPI). The index, which is composed of credit growth, stock price growth, bond yield, and

Macro Risk Perception (MRP), measures level of pressure in the financial sector. The second

one, called Macro Risk Perception (MRP) index, measures by how much market judges level

of risk. The index is composed of CPI inflation, FPI, and CA to GDP ratio.

Nominal

Exchange

Rate

GDP

RR

CAR

LTV

Stock PriceBond Yield Credit

CPI Inflation

BOP Surplus/

Deficit

Housing

Price

Portfolio

Investment

Default Risk

Nominal

Exchange

Rate

Policy Rate

Financial

Pressure

Index

Macro Risk

Perception

CA to GDP

RatioCPI Inflation

Figure 5 Financial Block

74

Table 8a Financial – Actual

Table 8b Financial – No Feedback Loop

Banking

Credits

Nominal (in million Rupiah) 1,307,688 1,437,930 1,765,845 2,200,094 2,707,862 3,292,874

Growth (%) 30.51 9.96 22.80 24.59 23.08 21.60

Real (in million Rupiah) 1,148,505 1,228,685 1,410,757 1,693,552 1,998,570 2,242,491

Growth (%) 17.51 6.98 14.82 20.05 18.01 12.20

CAR 18.37 17.64 17.55 17.18 17.72 18.56

RR 11.00 5.63 8.00 11.75 12.00 11.50

LTV 85.00 85.00 85.00 85.00 72.50 72.50

Financial Market

Stock Price 2,088 2,014 3,095 3,746 4,119 4,606

Growth (%) -5.58 -3.52 53.68 21.03 9.95 11.83

Bond Yield (10 y) 12.62 11.17 8.47 7.40 5.85 6.89

Household

Housing Price 76.76 86.96 100.00 115.14 127.65 140.91

Financial Pressure Index (FPI)

FPI 103.25 54.47 100.00 82.77 94.61 110.10

Macro Risk Perception (MRP)

MRP 123.02 65.11 100.00 85.56 107.74 131.82

20132012Items 2008 2009 2010 2011

Banking

Credits

Nominal (in million Rupiah) 3,396,211 3,396,211 3,396,211 3,396,211 3,396,211 3,396,211 3,292,874

Growth (%) 25.42 25.42 25.42 25.42 25.42 25.42 21.60

Real (in million Rupiah) 2,118,328 2,118,328 2,118,328 2,118,328 2,118,328 2,118,328 2,242,491

Growth (%) 5.99 5.99 5.99 5.99 5.99 5.99 12.20

CAR 16.26 16.26 16.26 16.26 16.26 16.26 18.56

RR 0.00 0.00 0.00 0.00 0.00 0.00 11.50

LTV 0.00 0.00 0.00 0.00 0.00 0.00 72.50

Financial Market

Stock Price 4,688 4,688 4,688 4,688 4,688 4,688 4,606

Growth (%) 13.83 13.83 13.83 13.83 13.83 13.83 11.83

Bond Yield (10 y) 3.01 3.01 3.01 3.01 3.01 3.01 6.89

Household

Housing Price 137.94 137.94 137.94 137.94 137.94 137.94 140.91

Financial Pressure Index (FPI)

FPI 146.16 146.16 146.16 146.16 146.16 146.16 110.10

Macro Risk Perception (MRP)

MRP 185.66 185.66 185.66 185.66 185.66 185.66 131.82

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.RR

BI Rate +

RR

BI Rate +

RR + LTV

Items

75

Table 8c Financial – With Feedback Loop

7. External

In this block, our focus is on exchange rate, export-import, and portfolio investment),

as shown in Figure 6. They are endogenous variables with behavioral equations. Real

exchange rate is affected by its lag, interest rate differential (policy rate minus LIBOR), risk

premium (proxied by GDP growth), reserves, Terms of Trade (TOT), productivity (TNT), and

regional currencies. The last three variables are not modelled. Based on value of real

exchange rate, we can count value of nominal exchange rate. Meanwhile export is affected

by world GDP, real exchange rate, and commodity prices (which is not modelled here). On

the other hand, import is affected by domestic demand, real exchange rate, export, and

commodity prices (which is not modelled here). In case of ‘no feedback loop’, portfolio

investment is affected by interest rate differential and stock price. On the other hand, in case

of ‘with feedback loop’, portfolio investment is affected also by Macro Risk Perception (MRP).

Economic condition, which is represented by GDP, also influences portfolio investment.

However, for simplicity it is not modelled here.

By multiplying export and import with nominal exchange rate, we get net export in USD.

Summing net export with income and transfers, we get current account. On the other hand,

summing portfolio investment with direct investment and other investment, we get capital and

Banking

Credits

Nominal (in million Rupiah) 3,183,383 3,183,383 3,183,383 3,183,383 3,183,383 3,183,383 3,292,874

Growth (%) 17.56 17.56 17.56 17.56 17.56 17.56 21.60

Real (in million Rupiah) 1,937,602 1,937,602 1,937,602 1,937,602 1,937,602 1,937,602 2,242,491

Growth (%) -3.05 -3.05 -3.05 -3.05 -3.05 -3.05 12.20

CAR 17.30 17.30 17.30 17.30 17.30 17.30 18.56

RR 0.00 0.00 0.00 0.00 0.00 0.00 11.50

LTV 0.00 0.00 0.00 0.00 0.00 0.00 72.50

Financial Market

Stock Price 4,087 4,087 4,087 4,087 4,087 4,087 4,606

Growth (%) -0.78 -0.78 -0.78 -0.78 -0.78 -0.78 11.83

Bond Yield (10 y) 4.19 4.19 4.19 4.19 4.19 4.19 6.89

Household

Housing Price 136.57 136.57 136.57 136.57 136.57 136.57 140.91

Financial Pressure Index (FPI)

FPI 148.78 148.78 148.78 148.78 148.78 148.78 110.10

Macro Risk Perception (MRP)

MRP 201.00 201.00 201.00 201.00 201.00 201.00 131.82

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With Policy

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

Items

76

financial account. Finally we get BOP surplus/deficit and reserves. We can also count CA to

GDP ratio CFA to GDP ratio. External block is shown in Table 9a – c, 10a – c, and 11a – c.

GDP

CPI Inflation

Nominal

Exchange

Rate

Policy Rate LIBOR

Real

Exchange

Rate

World CPI

Risk

Premium

Regional

CurrenciesTOT TNT

Domestic

DemandWorld GDP

ImportExport

Net Export Income Transfers

Current

Account

Portfolio

Investment

Direct

Investment

Other

Investment

Capital

Account

Financial

Account

Capital &

Financial

Account

BOP Surplus/

Deficit

CA to GDP

Ratio

CFA to GDP

Ratio

Reserves

Bond Yield

Stock Price

Import

Commodity

Prices

Export

Commodity

Prices

Forex

Intervention

Macro Risk

Perception

Figure 6 External Block

77

Table 9a External – Actual

Table 9b Exchange Rate – Actual

World GDP

Index in constant price 178.47 171.41 178.43 184.68 190.39 196.10

GDP growth -0.55 -3.96 4.10 3.50 3.09 3.00

Price

CPI 103.07 104.57 105.83 109.00 110.75 112.74

CPI Inflation 1.56 1.46 1.20 3.00 1.61 1.80

Policy Rate

LIBOR, 3 months 2.79 0.69 0.34 0.35 0.32 0.27

20132012Items 2008 2009 2010 2011

Exchange Rate

Nominal Exchange Rate 9,673 10,381 9,085 8,765 9,361 10,453

Appreciation(-)/Depreciation(+) 5.72 7.32 -12.48 -3.53 6.80 11.66

Real Exchange Rate 100.00 105.93 87.72 83.98 87.38 91.65

Appreciation(-)/Depreciation(+) -4.37 5.93 -17.19 -4.27 4.05 4.88

2013Items 2008 2009 2010 2011 2012

78

Table 9c Balance of Payment – Actual

In billion USD

I. Current Account 126 10,628 5,144 1,685 -24,418 -28,450

A. Goods 22,916 30,932 30,627 34,783 8,618 6,150

B. Services -12,998 -9,741 -9,324 -10,632 -10,331 -11,428

C. Income -15,155 -15,140 -20,790 -26,676 -26,800 -27,227

D. Current transfers 5,364 4,578 4,630 4,211 4,094 4,057

II. Capital and Financial Account -1,832 4,852 26,620 13,567 24,896 22,731

A. Capital account 294 96 50 33 51 21

B. Financial account -2,126 4,756 26,571 13,534 24,845 22,710

1. Direct investment 3,419 2,628 11,106 11,528 13,716 14,767

2. Portfolio investment 1,764 10,336 13,202 3,806 9,206 9,847

3. Other Invesment -7,309 -8,208 2,262 -1,801 1,922 -1,906

III.Total ( I + II ) -1,706 15,481 31,765 15,252 478 -5,720

IV. Net Errors and Omissions -238 -2,975 -1,480 -3,395 -262 -1,605

V. Overall Balance (III+IV) -1,945 12,506 30,285 11,857 215 -7,325

VI. Reverses and related items 1,945 -12,506 -30,285 -11,857 -215 7,325

Memorandum:

- Reserve Assets Position 51,639 66,105 96,207 110,123 112,781 99,387

Forex Intervention

- Current Account (% GDP) 0.00 2.00 0.70 0.20 -2.80 -13.00

- CA to GDP (%) 0.02 1.96 0.72 0.20 -2.78 -3.27

- CFA to GDP (%) -0.36 0.89 3.75 1.60 2.84 2.61

20132012Items 2008 2009 2010 2011

79

Table 10a External – No Feedback Loop

Table 10b Exchange Rate – No Feedback Loop

World GDP

Index in constant price 190.39 190.39 190.39 190.39 190.39 190.39 196.10

GDP growth 0.00 0.00 0.00 0.00 0.00 0.00 3.00

Price

CPI 112.74 112.74 112.74 112.74 112.74 112.74 112.74

CPI Inflation 1.80 1.80 1.80 1.80 1.80 1.80 1.80

Policy Rate

LIBOR, 3 months 0.00 0.00 0.00 0.00 0.00 0.00 0.27

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.RR

BI Rate +

RR

BI Rate +

RR + LTV

Items

Exchange Rate

Nominal Exchange Rate 11,596 11,596 11,596 11,596 11,596 11,596 10,453

Appreciation(-)/Depreciation(+) 23.88 23.88 23.88 23.88 23.88 23.88 11.66

Real Exchange Rate 93.13 93.13 93.13 93.13 93.13 93.13 91.65

Appreciation(-)/Depreciation(+) 6.57 6.57 6.57 6.57 6.57 6.57 4.88

RRBI Rate +

RR

BI Rate +

RR + LTV

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.

Items

80

Table 10c Balance of Payment – No Feedback Loop

In billion USD

I. Current Account -28,602 -28,602 -28,602 -28,602 -28,602 -28,602 -28,450

A. Goods 6,150

B. Services -11,428

C. Income -27,227 -27,227 -27,227 -27,227 -27,227 -27,227 -27,227

D. Current transfers 4,057 4,057 4,057 4,057 4,057 4,057 4,057

II. Capital and Financial Account 24,568 24,568 24,568 24,568 24,568 24,568 22,731

A. Capital account 21 21 21 21 21 21 21

B. Financial account 24,547 24,547 24,547 24,547 24,547 24,547 22,710

1. Direct investment 14,767 14,767 14,767 14,767 14,767 14,767 14,767

2. Portfolio investment 11,686 11,686 11,686 11,686 11,686 11,686 9,847

3. Other Invesment -1,906 -1,906 -1,906 -1,906 -1,906 -1,906 -1,906

III.Total ( I + II ) -4,034 -4,034 -4,034 -4,034 -4,034 -4,034 -5,720

IV. Net Errors and Omissions -1,605 -1,605 -1,605 -1,605 -1,605 -1,605 -1,605

V. Overall Balance (III+IV) -5,639 -5,639 -5,639 -5,639 -5,639 -5,639 -7,325

VI. Reverses and related items 5,639 5,639 5,639 5,639 5,639 5,639 7,325

Memorandum:

- Reserve Assets Position 107,142 107,142 107,142 107,142 107,142 107,142 99,387

Forex Intervention 0 0 0 0 0 0

- Current Account (% GDP) -13.00

- CA to GDP (%) -3.67 -3.67 -3.67 -3.67 -3.67 -3.67 -3.27

- CFA to GDP (%) 3.16 3.16 3.16 3.16 3.16 3.16 2.61

-5,432 -5,432 -5,432 -5,432 -5,432 -5,432

RRBI Rate +

RR

BI Rate +

RR + LTV

2013

No Feedback Loop

ActualNo Policy

With Policy

BI RateBI Rate + Fx

Intv.

Items

81

Table 11a External – With Feedback Loop

Table 11b Exchange Rate – With Feedback Loop

World GDP

Index in constant price 190.39 190.39 190.39 190.39 190.39 190.39 196.10

GDP growth 0.00 0.00 0.00 0.00 0.00 0.00 3.00

Price

CPI 112.74 112.74 112.74 112.74 112.74 112.74 112.74

CPI Inflation 1.80 1.80 1.80 1.80 1.80 1.80 1.80

Policy Rate

LIBOR, 3 months 0.00 0.00 0.00 0.00 0.00 0.00 0.27

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With Policy

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

Items

Exchange Rate

Nominal Exchange Rate 12,420 12,420 12,420 12,420 12,420 12,420 10,453

Appreciation(-)/Depreciation(+) 32.68 32.68 32.68 32.68 32.68 32.68 11.66

Real Exchange Rate 97.33 97.33 97.33 97.33 97.33 97.33 91.65

Appreciation(-)/Depreciation(+) 11.38 11.38 11.38 11.38 11.38 11.38 4.88

BI Rate +

RR

BI Rate +

RR + LTVBI Rate

BI Rate + Fx

Intv.RR

2013

With Feedback Loop

ActualNo Policy

With PolicyItems

82

Table 11c Balance of Payment – With Feedback Loop

In billion USD

I. Current Account -28,633 -28,633 -28,633 -28,633 -28,633 -28,633 -28,450

A. Goods 6,150

B. Services -11,428

C. Income -27,227 -27,227 -27,227 -27,227 -27,227 -27,227 -27,227

D. Current transfers 4,057 4,057 4,057 4,057 4,057 4,057 4,057

II. Capital and Financial Account 18,674 18,674 18,674 18,674 18,674 18,674 22,731

A. Capital account 21 21 21 21 21 21 21

B. Financial account 18,653 18,653 18,653 18,653 18,653 18,653 22,710

1. Direct investment 14,767 14,767 14,767 14,767 14,767 14,767 14,767

2. Portfolio investment 5,792 5,792 5,792 5,792 5,792 5,792 9,847

3. Other Invesment -1,906 -1,906 -1,906 -1,906 -1,906 -1,906 -1,906

III.Total ( I + II ) -9,958 -9,958 -9,958 -9,958 -9,958 -9,958 -5,720

IV. Net Errors and Omissions -1,605 -1,605 -1,605 -1,605 -1,605 -1,605 -1,605

V. Overall Balance (III+IV) -11,563 -11,563 -11,563 -11,563 -11,563 -11,563 -7,325

VI. Reverses and related items 11,563 11,563 11,563 11,563 11,563 11,563 7,325

Memorandum:

- Reserve Assets Position 101,218 101,218 101,218 101,218 101,218 101,218 99,387

Forex Intervention 0 0 0 0 0 0

- Current Account (% GDP) -13.00

- CA to GDP (%) -3.98 -3.98 -3.98 -3.98 -3.98 -3.98 -3.27

- CFA to GDP (%) 2.59 2.59 2.59 2.59 2.59 2.59 2.61

-5,463 -5,463 -5,463 -5,463

BI Rate +

RR

BI Rate +

RR + LTV

BI Rate + Fx

Intv.RR

-5,463 -5,463

BI Rate

2013

With Feedback Loop

ActualNo Policy

With PolicyItems

83

APPENDIX 2

MONETARY AND FINANCIAL STABILITY LINKAGE

AND MONETARY POLICY TRANSMISSION MECHANISM

Figure 1. Monetary and Financial Stability Linkage under Standard Monetary Policy Transmission Mechanism

Figure 1 describes a basic representation of standard monetary policy transmission

mechanism which takes place through different channels, affecting different markets and

variables that ultimately influence aggregate output and prices.

Monetary transmission is functioned after policy makers examine their monetary

strategy, response, and instruments. Policy actions taken on those considerations will then

directly influence economic agents’ expectation regarding macroeconomic indicators such as

inflation and financial risks. The actions also directly influence the resiliency and efficiency of

financial system (consists of financial intermediaries and financial markets). At the same time

however, the financial system itself is influenced by economic agents’ expectations.

The financial system will then create some necessary adjustments, reflected in a set

of variables describing monetary and financial conditions, such as interest rates, exchange

rate, credit, balance sheet, asset prices and money. All these variables joint forces with agents’

expectations to affect consumers and firms’ behavior in determining their savings-investment

strategy as well as wage and price setting. Taking all these responses in terms of aggregate

outcomes, the responses will be reflected in aggregate variables such as output, inflation and

national employment. Furthermore, there are feedback mechanisms between the financial

system and aggregate activity that may amplify any shocks that might happen between the

Financial System:

Intermediation

Resiliency

Efficiency

Interest Rates

Exchange Rate

Credit (Lending)

Balance Sheet

Asset Prices

Money Monetary Policy

Strategy, Response,

Instruments

Expectations

(e.g. inflation,

financial condition)

Aggregate Demand

Savings/Investment

Aggregate Supply

Employment

Wage & Price Setting

Other Aggregate

Outcomes:

Economic Growth,

Employment

Monetary Stability

Monetary policy feedback rule

84

two. Any changes in economic activity, employment, inflation and inflation expectations will be

considered in the monetary policy feedback rule by central banks in formulating monetary

policy actions.

The above monetary policy transmission will be enriched once we consider a case

where risk perception takes place and influences the mechanism. This has become

pronounced especially since the occurrence of the global financial crisis of 2008/2009.

Moreover, we can grab more understanding regarding monetary and financial stability linkage

under this case.

Figure 2. Monetary and Financial Stability Linkage beyond Standard Monetary

Transmission Mechanism

Figure 1 describes a different work of transmission mechanism in the presence of risk

perception. In an event when the economy moves at an expansion phase characterized by

macroeconomic stability and escalating growth, investor confidence raises optimism when

assessing the economy. This will lead to a so-called risk-taking behavior, which firstly triggered

by monetary policy actions in a low real interest rate environment, while at the same time

influences the policy actions themselves. The risk perception through the financial system will

eventually push up credit demand and asset prices.

Financial System:

Intermediation

Resiliency

Efficiency

Interest Rates

Exchange Rate

Credit (Lending)

Balance Sheet

Asset Prices

Money Monetary Policy

Strategy, Response,

Instruments

Expectations

(e.g. inflation,

financial condition)

Aggregate Demand

Savings/Investment

Aggregate Supply

Employment

Wage & Price Setting

Other Aggregate

Outcomes:

Economic Growth,

Employment

Monetary Stability

Monetary policy feedback rule

Financial Stability Framework

Micro-prudential

Policy

Macro-prudential

Policy

Risk Perception

(Risk Taking) Financial Stability

Macro-prudential policy

feedback rule

Policy mix

Linkage

85

Changes in financial sector as reflected in adjustments of financial variables influence

aggregate outcomes such as economic growth and employment, which are directly linked to

monetary stability. This is where a linkage between financial stability and monetary stability

occurs. A healthy macroeconomic environment and monetary stability has bidirectional

feedback with financial system stability. Any developments between monetary and financial

stability will be considered by monetary policy makers through macro-prudential policy

feedback rule, which are scrutinized under financial stability framework.

The financial stability framework consists of micro- and macro-prudential policies.

Micro-prudential policy investigates soundness of financial institutions, while macro-prudential

policy examines the overall soundness of the financial system. The policies, together with

monetary policy, are employed by the monetary authorities in terms of policy mix to support

the effectiveness and efficiency of monetary policy implementation.

Within this policy perspective, in order to strengthen the framework of monetary and

financial system stability, central bank is demanded to be more flexible and creative in

responding to emerging uncertainties within the economy and to think beyond public

perception. Such a flexibility is not only linked to the adjustment preference to control inflation

and manage macroeconomy on the one hand, and to put the role of financial system stability

on the other hand, but it is also crucial to overcome the conflict potential or “trade-off” between

targeting monetary stability and financial system stability itself.