Definition, Objectives, and Monetary Policy Instruments

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Understanding Monetary Policy

Monetary policy is basically a policy that aims to achieve internal balance (high economic growth, price stability, equitable development) and external balance (balance of payments balance) and the achievement of macroeconomic objectives, namely maintaining economic stabilization that can be measured by employment opportunities, price stability and a balanced international balance of payments.

If stability in economic activity is disrupted, monetary policy can be used to restore (stabilization measures). The influence of monetary policy will first be felt by the banking sector, which is then transferred to the real sector. Monetary policy is defined by the plans and actions of a coordinated monetary authority to maintain monetary balance, and stabilize the value of money, encourage smooth production and development, and expand employment opportunities to improve people's lives.

Wikipedia provides a definition of monetary policy with a process undertaken by the government, central bank, or monetary authority of a country to control, supply of money, availability of money, interest rates, in order to achieve a set of orientation goals for economic growth and stability. Where monetary policy is usually known as a choice between expansion policy or contraction policy.

So it can be concluded from the above understanding that monetary policy is all the efforts or actions of the central bank to influence monetary developments (money supply, interest rates, credit and exchange rates) to achieve certain economic goals. As part of macroeconomic policy, the purpose of monetary policy is to help achieve macroeconomic goals including: economic growth, employment opportunities, price stability and balance of payments. These four targets are the objectives / final targets of monetary policy (final target).

Ideally, all monetary policy objectives must be achieved simultaneously and sustainably. However, experience in many countries, including Indonesia, shows that this is difficult to achieve, and there is even a contradictory tendency. For example, contractive monetary policies to curb inflation can have a negative effect on economic growth and job creation.

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Types of Monetary Policy

Monetary policy is basically a policy that aims to achieve internal balance (high economic growth, price stability, equitable development) and external balance (balance of payments balance) and the achievement of macroeconomic objectives, namely maintaining economic stabilization that can be measured by employment opportunities, price stability and a balanced international balance of payments.

If stability in economic activity is disrupted, monetary policy can be used to restore (stabilization measures). The influence of monetary policy will first be felt by the banking sector, which is then transferred to the real sector. Monetary policy can be classified into two namely:

Expansive monetary policy (Monetary expansive policy)

Is a policy in order to increase the amount of money in circulation. This policy is carried out to overcome unemployment and increase people's purchasing power (public demand) when the economy experiences a recession or depression. This policy is also called easy monetary policy (easy money policy)

Monetary contractive policy

Is a policy in order to reduce the amount of money in circulation. This policy is carried out when the economy experiences inflation. Also called the tight money policy (tight money policy)

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Monetary Policy Objectives

Bank Indonesia has the objective to achieve and maintain the stability of the value of the rupiah. This objective as stated in Law No. 3 of 2004 article 7 concerning Bank Indonesia. What is meant by the stability of the value of the rupiah, among others, is the stability of the prices of goods and services reflected in inflation.

To achieve this goal, since 2005 Bank Indonesia has implemented a monetary policy framework with inflation as the main target of monetary policy (Inflation Targeting Framework) by adopting a free floating exchange rate system. The role of exchange rate stability is very important in achieving price stability and the financial system. Therefore, Bank Indonesia also operates an exchange rate policy to reduce excessive exchange rate volatility, not to direct the exchange rate to a certain level.

In its implementation, Bank Indonesia has the authority to conduct monetary policy through setting monetary targets (such as money supply or interest rates) with the main objective of maintaining the inflation rate target set by the Government. Operationally, controlling these monetary targets uses instruments, including open market operations on the money market both in rupiah and foreign currencies, setting discount rates, setting minimum reserve requirements, and arranging credit or financing. Bank Indonesia can also use monetary control methods based on Sharia Principles.

In general, the objectives of monetary policy include:

  • Circulate the currency as a medium of exchange (medium of exchange) in the economy.
  • Maintaining a balance between economic liquidity needs and price level stability.
  • Optimal liquidity distribution in order to achieve the desired economic growth in various economic sectors
  • Helping the government carry out its obligations which cannot be realized through normal sources of revenue.
  • Maintaining Economic Stability This means that the flow of goods and services is balanced with the growth of goods and services available.
  • Maintaining Price Stability. The price of an item is the result of interaction between the amount of money in circulation and the amount of money available in the market.
  • Increasing employment opportunities, when the economy is stable employers will make investments to increase the amount of goods and services so that the investment will open new jobs so as to expand employment opportunities for the community.
  • Improving the Trade Balance of Community Work By increasing exports and reducing imports from abroad entering the country or vice versa.

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Monetary Policy Function

From the notion of monetary policy is a policy taken by the government (Central Bank) to increase and reduce the amount of money in circulation.

Since 1945, monetary policy has only been used as economic policy to achieve short-term economic stability. The fiscal policy is used in long-term economic control. However, at this time monetary policy is the main policy used for short-term and long-term economic control. To influence the money supply, the government can implement a tight money policy and a loose money policy.

1. Tight Money Policy, namely the policy of the Central Bank to reduce the amount of money in circulation by:

  • a. Increase interest rates
  • b. Selling securities
  • c. Increase in cash reserves
  • d. Limit lending

2. Easy Money Policy, which is a policy carried out by the Central Bank to increase the amount of money in circulation by:

  • a. Lower interest rates
  • b. Buy securities
  • c. Decrease cash reserves
  • d. Give loose credit.

Considering the specific tasks carried out by Bank Indonesia, Bank Indonesia cannot fully control inflation, especially inflationary pressure originating from the supply side (cost push inflation). Bank Indonesia, through monetary policy, can affect inflation on the demand side, such as investment and public consumption. For example, an increase in interest rates can reduce public and government spending, thereby reducing overall demand, which in turn can reduce inflation. In addition, the increase in interest rates can strengthen the exchange rate through an increase (positive) interest rate differential.

Likewise, Bank Indonesia can influence public expectations through consistent and credible policies. The hope is that the inflation target of Bank Indonesia is referred to by the public and economic actors so that the inflation that occurs can be the same or close to the inflation target. If this condition occurs, then the cost of monetary control can be minimized.

In theory, monetary policy can be transmitted through various channels, namely the interest rate channel, the bank credit channel, the company balance sheet channel, the exchange rate channel, the asset price channel, and the expectation channel. By going through these channels, monetary policy will be transmitted and affect the financial sector and the real sector after some time (lag of monument policy).

In addition to monetary policies that are "direct" as above, the central bank can also influence its ultimate goal "indirectly", namely through various regulations and appeals (moral suassion) to the banking sector to accelerate the transmission mechanism of monetary policy. In exercising monetary control, Bank Indonesia is given authority to use monetary instruments in the form of but not limited to open market operations, setting discount rates, setting minimum reserve requirements, and arranging credit or financing.

There are several conditions that must be met so that monetary policy can achieve success in its implementation. The prerequisites include:

  1. Central Bank Indepensi.
    Actually there is no Central Bank that can be truly independent without government interference. However, there are policy instruments that are not influenced by the government, for example through fiscal policy.

  2. Focus on goals.
    Controlling inflation is only one of several other targets that the Central Bank intends to achieve. Other targets sometimes conflict with inflation control goals, such as economic growth targets, employment opportunities, balance of payments, and exchange rates. Therefore, the Central Bank should not set other targets and focus on the main target of inflation control.

  3. Capacity to forecast inflation.
    The Central Bank absolutely must have the ability to predict inflation accurately, so that it can set the inflation target to be achieved.

  4. Central Bank instrument supervision must have the ability to oversee monetary policy instruments.

  5. Implement consistently and transparently.
    With the consistent and transparent implementation of the inflation target, the public's trust in the policies stipulated will increase.

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Monetary Policy Instruments

Instruments that can be utilized by the government in efforts to make monetary policy include:

  1. Open Market Operation Policy Open
    market operation is one of the policies decided by the central bank to increase or decrease the amount of money in circulation. This policy was adopted by selling SBIs (Bank Indonesia Certificates) or buying securities in the capital market.

  2. Discount Policy Discount
    Policy is a reduction or increase in the amount of money circulating in the community by changing commercial bank discounts. If the central bank has calculated the amount of money in circulation exceeds the need (a symptom of inflation), then the central bank; will take policies to raise interest rates. With this policy, it will automatically stimulate the arrival of people to save money.

  3. Cash Reserve Policy The
    central bank can draw up regulations to regulate (increase and decrease) existing cash reserves (cash ratio). Commercial banks accept money from customers (savings, current accounts, certificates of deposit, etc.) which of course there is a certain percentage of the currency deposited by the customer.

  4. Strict Credit Policy Credit is
    still provided by commercial banks, but the grant must be based on conditions covering 5C, namely Character, Capability, Collateral, Capital, and Condition of Economy. With tetat credit economic policy, an efficient amount of money can easily be monitored. This kind of policy can also be taken when the economy is experiencing symptoms of inflation.

  5. Moral Encouragement Policy The
    central bank is able to influence the amount of money in circulation with various forms such as speeches, announcements, and circulars aimed at commercial banks and other monetary actors. The contents of the announcement include a call or an invitation to hold a savings loan.

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Monetary Wisdom Tool

Monetary policy can be carried out by implementing monetary policy instruments, which include:

  • Open market operations of rupiah or foreign exchange money

Open market operations are a way of controlling money in circulation by selling or buying government securities. If you want to increase the money supply, the government will buy government securities. However, if you want the amount of money circulating to decrease, the government will sell government securities to the public. Government securities include but are not limited to SBIs or abbreviations from Bank Indonesia Certificates and Money Market Securities (SBPU).

  • Determination of minimum required reserves

The politics of cash reserves means policies to increase or decrease the cash reserves that must exist in commercial banks. If economic conditions increase in price (inflation), the central bank can increase its minimum cash reserves so that the money in circulation can be reduced. Conversely, if economic conditions are sluggish, the government can reduce its minimum cash reserves, so that the money in circulation increases because of the large number of loans given to the public. As a result of the increase in cash reserves, the ability of commercial banks to provide loans is reduced or commercial banks are unable to provide loans and at the same time idle funds in banks increase.

  • Determination of the discount rate

Determination of the discount rate is setting the amount of money in circulation by playing the interest rate of the central bank at commercial banks. Commercial banks sometimes have a shortage of money so they have to borrow from the central bank. To make the amount of money increase, the government lowered the central bank's interest rate, and conversely raised the interest rate to make the money supply reduced.

  • Credit or financing arrangements

Credit or financing arrangements are policies to tighten or facilitate lending to the public. To regulate economic activities to grow better, the government (Bank Indonesia) can selectively supervise loans with the aim of ensuring that commercial banks provide loans and make investments as desired by the government. For example, to encourage the industrial sector, the central bank can make regulations that require commercial banks to lend part of their funds to industrial sector businesses with light conditions.

  • Other policies deemed necessary

Besides the policy tools above, there are still more policy tools that can and have been implemented by Indonesia:

  1. Moral
    persuasion Moral appeal is a monetary policy to regulate the money supply by appealing to economic actors. Examples such as calling on the lenders to be careful in issuing credit to reduce the money supply and to urge banks to borrow more money from the central bank to increase the money supply to the economy.

  2. Sanering
    Sanering is a policy to cut banknotes in circulation into two parts, one part or half of the nominal value which is replaced by new banknotes and the other half is replaced by state bonds. This policy occurred during the reign of Sukarno.

  3. Substitution of money
    This policy is to replace old money with new money with a comparison of old money worth Rp. 1000, - replaced with new money with a nominal value of one rupiah. This policy was implemented at the end of the Sukarno policy or the beginning of the Suharto government.

  4. Devaluation
    Devaluation is related to the government's policy to reduce the value of domestic money against the value of foreign money.

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Monetary Policy Operations

Monetary policy operations consist of monetary instruments, operational targets, intermediate targets, and final targets.

  • Monetary instruments

Monetary policy can be carried out by implementing monetary policy instruments, which include:

1. Open Market Operations
This instrument is the most important monetary policy tool because it is the main determinant between changes in interest rates and monetary base and is the main source for influencing fluctuations in the money supply. Open market operations include the act of selling or buying government securities. If you want to increase the money supply, the government will buy government securities. However, if you want the amount of money circulating to decrease, the government will sell government securities to the public. Government securities include, among others, SBI (Bank Indonesia Certificates) and SBPU (Money Market Securities).

Open market operations have two main influences on money market conditions, namely first, increasing the reserves of commercial banks participating in transactions. This is because in the purchase of securities for example, the central bank will increase the reserves of commercial banks that sell these securities, consequently commercial banks can increase the amount of money in circulation (through the process of creating credit). When the central bank sells securities on the open market, the reserves of commercial banks will decrease. Next these banks are forced to reduce lending, thereby reducing the money supply. The second effect, the act of buying or selling securities will affect the price (and thus the interest rate) of securities,

Based on its objectives, tebuka market operations are divided into two types namely:

  • Dynamic open market operation
    Aims to change the amount of reserves and monetary base.
  • Defensive open market operations
    Aim to control other factors that can affect the amount of reserves and monetary base.

2. Discount Rate
This policy includes actions to change the interest rate that must be paid by commercial banks in terms of borrowing funds from the central bank. This policy basically aims to influence the discount rate which in turn will affect the money supply through changes in loan interest rates. By increasing the discount, the cost of borrowing funds from the central bank will rise so that it will reduce the desire of commercial banks to lend to the central bank. As a result, the money supply can be reduced or reduced. In addition, the position of the amount of reserves can also be influenced through this instrument. If the discount rate increases, it will increase the cost of loans to the bank. This increase in reserves is an indication that the central bank is implementing a strict monetary policy.

3. Determination of the minimum reserve requirement (minimum reserve requirement)
Mandatory reserve ratio is regulating the amount of money in circulation by playing the amount of bank reserve funds that must be deposited with the government. If the minimum reserve requirement is lowered, it will result in an increase in the amount of deposits so that the money supply tends to increase and vice versa if the minimum reserve requirement is increased, it will reduce the amount of deposits which will ultimately reduce the amount of money in circulation. So as to increase the amount of money, the government reduced the mandatory reserve ratio. To decrease the money supply, the government raised the ratio.

4. Moral Appeal (Moral Persuasion) Moral
appeal is a monetary policy to regulate the money supply by appealing to economic actors. This policy was carried out by Bank Indonesia by asking or urging banks to always consider the macroeconomic conditions and micro conditions of each bank in preparing a reality loan expansion plan. This moral persuasion policy is basically intended to encourage banks to always apply the precautionary principle in providing credit,

to reduce the money supply and urge banks to borrow more money from the central bank to increase the money supply to the economy while still giving banks the freedom to grow and develop based on market mechanisms.

  1. Selective credit
    Central bank politics to reduce the amount of money in circulation by tightening lending.
  2. The politics of sanering The
    politics of sanering is done when hyper inflation has occurred. This policy was carried out by Bank Indonesia on December 13, 1965, which cut money from Rp 1,000 to Rp 1.

  • Operational Targets

The operational target variable is used to direct intermediate goals. Setting operational targets depends on which pathway is believed to be effective in the transmission of monetary policy. Operational target criteria include:

  1. Selected from monetary variables that have a stable relationship with the target.
  2. Can be controlled by the central bank.
  3. Available more immediately than intermediate targets, accurate and not often revised

  • The intermediate targets ( intermediate targets )

The relationship between operational targets and monetary policy ultimate objectives is indirect and complex. For this reason, monetary experts and central bank practitioners designed a  simple rule  to help implement monetary policy by adding indicators called intermediate targets. Intermediate targets are indicators for assessing the success of monetary policy, these targets are selected from variables that have a stable relationship with inflation, wide scope, can be controlled by the central bank, are available relatively quickly, accurately and are not often revised, including monetary aggregates including M1 (currency and demand deposits) and M2 (total money supply), bank credit, and exchange rates.

  • Final goal ( final target )

The ultimate goal or objective of monetary policy depends on the objectives mandated by the laws of a country's central bank. For example Article 7 paragraph (1) of Law Number 3 of 2004 concerning BI explicitly states that the ultimate goal of monetary policy is to achieve and maintain stability of the rupiah value (monetary stability). Taylor (1995) states that the monetary policy transmission mechanism is the monetary policy transmission mechanism is the pathways through which monetary policy influences the ultimate goal of monetary policy, namely inflation.

Final goal (final target)

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Bank Indonesia Monetary Policy

1. Price Stability vs Economic Growth

A few decades ago, monetary policy was actively used to stimulate the economy and employment, so that the pace of economic growth was at its potential level. The role of Bank Indonesia as a central bank in the context of managing the macro economy is more focused on maintaining price stability. In Law No. 23/1999 concerning Bank Indonesia, there is a rethinking in formulating monetary policy objectives that is far more focused than the previous law, namely maintaining the stability of the value of the rupiah.

From the point of view of the central bank, the main rationality of implementing a single objective of price stability is based on the relevance of these targets as the objectives of monetary policy. In the long run. Policies that can be carried out by a central bank through the demand side, can only affect the nominal value of money, while the real economic activity is determined in the real sector, for example through policies that can affect productivity.

The government prioritizes economic growth, especially in Indonesia is more driven by the level of public consumption. Thus, it can provide a challenge for Bank Indonesia in maintaining price stability and achieving the inflation target set. The monetary policy paradigm is often called the "activist monetary policy". This paradigm is inseparable from the belief that in the long run there is a "trade off" between unemployment and inflation, otherwise known as the Philips curve (Mankiw, 2000: 335-337). This means that in the long run, the central bank can encourage economic growth permanently at the expense of inflation at a certain level.

In macroeconomic management, usually the policy choices offered are limited to short-term economic policies that can increase aggregate demand. On this view, supporters of the single target of inflation tend to conclude that the trade off that may occur is only short term. In the long run, achieving price stability will actually support the achievement of sustainable economic growth. With an inflation target that is compatible , monetary policy can be directed to influence aggregate demand so that it is in line with the capacity of the economy from the supply side (Sabirin, 2002: 4).

2. Inflation Targeting Framework (ITF) as a Monetary Policy Framework

This framework has been formally applied since July 2005, after previously using monetary policy that applies  base money  as the target of monetary policy. Economic performance in the past was not very encouraging. Not long after the monetary crisis hit Indonesia, there were fundamental changes in the formulation of Indonesian monetary policy. If before the crisis the monetary policy was directed to realize several objectives, such as economic growth, employment opportunities, price stability, and broader development goals, then the current policy has only one goal, namely to maintain and realize a low inflation rate or referred to as monetary policy with a single target (inflation) (Ismail, 2003: 1).

In order to achieve the inflation target, monetary policy carried  forward looking , which means that changes in  the stance  of monetary policy be conducted through evaluation whether future inflation still in line with the inflation target has been launched. In this framework, monetary policy is also characterized by transparency and accountability of policies to the public. Operationally,   the stance  of monetary policy is reflected by the establishment of a policy rate (BI Rate) that are expected to affect the money market interest rates and deposit rates and bank lending rates. This change in interest rates will ultimately affect  output  and inflation.

In monetary terms, a policy framework based on achieving an inflation target announced to the public is explicitly referred to as an inflation targeting framework . The inflation target can be seen as a policy anchor that will determine the policy response taken by the central bank. Implementing an inflation targeting policy is not as easy as one might imagine. This is due to the many monetary and non-monetary factors that are difficult to control by the central bank as the institution responsible for implementing monetary policy (Ismail, 2003: 1).

Each period, Bank Indonesia evaluates whether future inflation projections are still in line with the targets set. This projection is carried out with a number of models and some information that can illustrate the condition of future inflation. If the inflation projection is not compatible with the target, Bank Indonesia responds using the instruments it has. For example, if the inflation projection exceeds the target, Bank Indonesia will tend to make monetary tightening.

Regularly, Bank Indonesia explains to the public the assessment of inflation conditions and the  outlook  for the future and the decisions taken. If the inflation target is not achieved, an explanation is needed to the public and steps to be taken to restore inflation in accordance with the target.

In a crisis of economic conditions, the government pursues policies that tend to be expansive, in order to encourage rapid economic growth. But this tends to put pressures on inflation. While on the other hand through the determination of inflation targeting the central bank tends to lead to policies to create low and stable inflation. In the framework of inflation targeting, the monetary authority has the freedom to determine the stance of the policy to be taken, but this freedom is limited by the commitment to achieve a certain inflation target.

In general, the implementation of monetary policy in achieving the final target, both the inflation control target and economic growth, can be done through two approaches, namely quantity targeting and price targeting . In other words, monetary policy strategies are based on controlling money supply or interest rates.

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Monetary Policy Implications

  1. Economic Growth
    From the demand side, the main source of economic growth will still be supported by consumption activities. Meanwhile, given the global conditions that are not too conducive, export growth and investment are not expected to experience a significant increase. While from the supply side, all economic sectors are expected to experience positive increases in activities, such as the manufacturing industry sector, the trade sector, and the transportation sector being the main contributors to economic growth (BI Report, 2003: 16).

  2. Inflation Rate
    In the field of inflation, despite the pressure of demand, in general developments have begun to show a tendency for price pressures that are not too high.

  3. Exchange Rates
    In general, the rupiah exchange rate in the fourth quarter of 2003 moved relatively stable with a tendency to weaken.

  4. Interest Rates
    Along with the improvement in economic and monetary indicators, especially the reduced inflationary pressures and the relatively stable domestic exchange rate have a positive impact on interest rates. The decline in SBI interest rates does not necessarily reduce the interest rates on bank loans. This means that the intermediary function of banks in Indonesia does not appear to have fully recovered.

  5. Base money
    In monetary control, Bank Indonesia has an operational target, which is to maintain the base money level to match the real needs of the economy and be consistent with achieving the inflation target.

  6. Banking
    In general, the performance of the banking sector has not shown significant improvement. Although several banking indicators, namely third party fund collection (TPF) and capital, have increased, other indicators, such as the composition of earning assets, credit development, and new credit distribution are still not optimal.

The development and prospects of the current monetary economy require efforts to maintain the momentum of success achieved. For this reason, monetary policy must be pursued consistently through excess liquidity absorption through Open Market Operations (OPT), so that base money stays below the indicative target so as not to cause new pressures on inflation and the exchange rate. With various developments and changes that are based in the economy and the financial sector, the old paradigm of monetary policy through money supply transmission needs to be reviewed. Transmission of monetary policy through quantities, such as money supply and credit is believed to be not as strong as in the past. Transmission mechanisms through prices, such as interest rates and exchange rates,

In the banking sector, in order to support the effectiveness of monetary policy, the main focus of banking policy is still to concentrate on the continuation of the banking restructuring program and improving the banking intermediary function. In addition, the increase in bank supervision is an effort to maintain the Bank's Capital Adequacy Ratio (CAR) which has reached 8%, especially for banks whose capital structure is still vulnerable to the influence of rising interest rates, weakening exchange rates, and declining credit quality. Efforts to restore the economy and maintain stability in the financial system are highly dependent on supporting aspects outside the economy, such as domestic security, social and politics. Therefore, as part of the overall macroeconomic policy framework, Bank Indonesia policies in the monetary, banking,

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Monetary and Banking Policy

Monetary and banking developments in Indonesia since the new order basically can be classified into 3 periods, namely:

1. Economic stabilization and rehabilitation period.

Monetary and banking policies during the period of economic stabilization and rehabilitation at the beginning of the new order were basically to overcome the very poor economic conditions at that time. although there is no definite and agreed-upon inflation rate, various observers estimate the inflation rate to be around 650% per year, a fantastic number compared to the economic conditions of neighboring countries at that time.

To prevent the inflation rate, the government is trying to control the inflation rate to a safer limit, increase exports, and provide adequate clothing for the people. In the context of controlling inflation, two main policies are adopted. First change the budget deficit policy into a balanced budget. Second, run a very strict and qualitative credit policy. During this period the government, as part of the economic restructuring, also restructured the banking system by issuing Law No. 14 of 1967 concerning Banking Fundamentals and Law No. 13 of 1968 concerning Bank Indonesia.

2. The period when the economy was supported by the oil sector.

Government policy in the effort to mobilize public funds as a source of development financing accompanied by the provision of low-interest Bank Indonesia Liquidity Credit (KLBI) increases the ability of banks to extend credit. The provision of KLBI in large quantities due to the large amount of state revenue from oil exports in the mid-1970s, known as the "oil boom", has pushed inflation back high.

Monetary policies pursued during this oil boom period include:

  • a. Establish a credit ceiling and other assets.
  • b. Increase credit interest.
  • c. Increase deposit interest.
  • d. Raise the mandatory liquidity reserve provisions.

3. The period of banking deregulation.

Entering the 1980s the Indonesian economy experienced a recession as a result of the world recession. Gross domestic product dropped dramatically to only 2.2% compared to an average of 7.7% in previous years, even reaching 9.9% in 1980. Meanwhile, the balance of payments continued to deteriorate and there was even a deficit of USD 1,930 million in 1982. To overcome the worsening economic conditions, the government made changes in economic policy, including monetary and banking.

The policies pursued by the government at the time included:

  • a. Adjustment of the exchange rate of the rupiah against the US dollar in March 1983 from Rp 700 to Rp 970.
  • b. Rescheduling projects that use large amounts of foreign exchange.
  • c. Deregulating the monetary and banking sectors with various types of policy packages.

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Economic Recovery in Monetary Policy

1. Indonesian monetary crisis

The crisis that hit the nation of Indonesia, became the beginning of the decline of a country with abundant natural resources. From the beginning of 1998, since the new order era, Indonesia's decay has begun to decline, especially in the economic field. The exchange rate weakened, inflation was out of control, as well as the underdeveloped economic growth in the country.

In June 1997, Indonesia was seen far from a crisis. Unlike Thailand, Indonesia has low inflation, a trade surplus of more than 900 million dollars, a large foreign exchange stock, more than 20 billion dollars, and a good bank sector. But many Indonesian companies borrow many US dollars. In the following year, when the rupiah strengthened against the dollar, this practitioner worked well for the company - the level of effectiveness of their debt and financial costs had decreased when the price of the local currency increased.

In July, Thailand symbolized the baht, the Indonesian Monetary Authority widened the trade channel from 8 percent to 12 percent. The Rupiah began to be strongly attacked in August. On August 14, 1997, floating exchanges were regularly exchanged with free-floating exchanges. Rupiah fell deeper. The IMF came with a 23 billion dollar aid package, but the rupiah fell even deeper because of fears of corporate debt, the sale of the rupiah, strong dollar demand. The Rupiah and the Jakarta Stock Exchange touched the lowest point in September. Moody's reduced Indonesia's long-term debt to "junk bonds".

Although the rupiah crisis began in July and August, this crisis strengthened in November when the effects of the devaluation in the summer appeared on the company's balance sheet. Companies that borrow in dollars must face greater costs caused by the decline in the rupiah, and many react by buying dollars, namely: selling rupiah, lowering the price of the rupiah even further.

Rupiah inflation and a large increase in food prices have caused chaos in the country. In February 1998, President Suharto sacked the Governor of Bank Indonesia, but this was not enough. Suharto was forced to resign in mid-1998 and BJ Habibie became president. Until 1996, Asia attracted almost half of the capital flows of developing countries. However, Thailand, Indonesia and South Korea have "current account deficits" and the maintenance of pegged exchange rates encourages external lending and leads to excessive exposure to the risk of foreign exchange exchange in the financial and corporate sectors.

Economic actors have been thinking about the effects of Mainland China on the real economy as a contributing factor to the crisis. The PRC had effectively begun competition with other Asian exporters especially in the 1990s after implementing export-oriented reforms. Most importantly, the currencies of Thailand and Indonesia are closely related to the dollar, which rose in value in the 1990s. Western importers are looking for cheaper producers and find them in China which costs are lower than the dollar.

2. Economic recovery after the monetary crisis

The stability of prices and exchange rates is a prerequisite for economic recovery because without it the economic activities of the community, the business sector and the banking sector will be hampered. Therefore, it is not excessive if the main focus of Bank Indonesia's monetary policy during the economic crisis is to achieve and maintain stable prices and the exchange rate of the rupiah. Moreover, Law No. 23 of 1999 concerning Bank Indonesia clearly states that the  objective of Bank Indonesia is to achieve and maintain the stability of the value of the rupiah, which contains the terms of price stability (inflation rate) and the stability of the exchange rate . In other words, in accordance with Law No. 23 of 1999 the objective of Bank Indonesia monetary policy is only one ( single objective), which is maintaining the stability of the rupiah value. This is different from the old Central Bank Law, namely Law no. 13 of 1968, which demanded Bank Indonesia to meet several objectives at the same time ( multiple objectives ), namely encouraging economic activity, expanding employment opportunities, and maintaining the stability of the value of the rupiah, whose achievements can essentially contradict each other, especially in the short term.

To achieve the above objectives, Bank Indonesia is still implementing a monetary policy framework based on controlling the money supply or what is known in the academic community as a  quantity approach . Within this framework Bank Indonesia seeks to control  base money (base money)  as the operational target of monetary policy. With a controlled base money, the development of the money supply is also expected to be controlled. Furthermore, with a controlled money supply, it is expected that the aggregate demand for goods and services will always move in a balanced amount with the ability of national production so that prices and exchange rates can move stably.

Using the monetary policy framework as described above, Bank Indonesia in the early period of the economic crisis, especially during 1998, implemented a tight monetary policy to restore monetary stability. Tight monetary policy had to be carried out because during this period inflation expectations in the community were very high and the money supply increased very rapidly.

In the midst of high inflation expectations and the risk level of holding the rupiah, efforts to slow the rate of money supply growth have driven the sharp rise in domestic interest rates. High interest rates are needed so that people want to hold the rupiah and not spend it on things that are not urgent and do not use it to buy foreign exchange.

Efforts to restore monetary stability through the implementation of tight monetary policies, which are assisted by efforts to restore public confidence in national banks, have begun to produce positive results since the fourth quarter of 1998. Slowing money supply growth and high deposit rates in banks have reduced opportunities and people's desire to hold their eyes foreign money so that the depreciating pressure of the rupiah gradually recedes. Since mid-1998 the exchange rate of the rupiah against the USD has tended to strengthen and then moved relatively stable during 1999.

In accordance with the floating exchange rate system implemented since August 14, 1997, the development of the rupiah exchange rate is largely determined by market mechanisms. Within this system, the strengthening of the rupiah exchange rate that occurred from mid-1998 to the end of 1999 was more due to the easing of foreign exchange demand pressures in line with controlled money supply and lower inflation expectations.

Bank Indonesia only sells foreign exchange through market mechanisms at market prices to sterilize or suck up the monetary expansion that comes from financing the government's budget deficit and is not primarily aiming to direct the rupiah exchange rate to a certain level. The foreign exchange sales did not endanger the position of Bank Indonesia foreign exchange reserves because they use foreign exchange that comes from withdrawing government foreign debt which is intended to support financing the government's budget deficit.

The strengthening rupiah exchange rate and supported by the improved supply and distribution of staple goods have driven the decline in inflation since the beginning of the fourth quarter of 1998. In fact, the monthly inflation rate that had reached 12.67% in February 1998, recorded a negative number or deflation in October 1998. The deflation then continued seven times in a row during the period March to September 1999. With this development, the inflation rate during 1999 only reached 2.0%, far lower than the inflation rate during 1998 which reached 77.6%. It means that Indonesia has successfully avoided the danger of hyperinflation which had threatened during the first half of 1998.

In subsequent developments, the very low inflation rate and the rupiah exchange rate which has strengthened considerably compared to the height of the crisis has provided room for Bank Indonesia to relax monetary policy and encourage domestic interest rates to decline. As a reflection of monetary policy that is somewhat loose, the annual growth of the indicative target of base money which previously continued to be reduced to reach 11.2% in June 1999, since the beginning of the second semester of 1999 began to be increased to reach 15.7% in March 2000. Correspondingly, the interest rate 1 month SBI interest which has been the benchmark ( benchmark)) for banks continued to decline from the highest level of 70.58% in September 1998 to 11.0% at the end of April 2000. The sharp decline in SBI interest rates was followed by interbank money market rates (PUAB) and banking deposits at a rate of almost the same decrease.

The economists agree that the characteristics of a country that are vulnerable to the monetary crisis are if the State:

  1. Have a substantial amount of foreign debt
  2. Experienced uncontrolled inflation
  3. Large balance of payments deficit
  4. Currency exchange rates are not balanced
  5. Interest rates above reasonable
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