How Indonesia's monetary policy affects key variables

The objective of this paper is to examine the determination of interest rates, inflation and nominal exchange rates in Indonesia, and investigate the role of monetary policy in affecting these variables. In the short term, monetary policy can be used to protect domestic interest rates from the destabilizing influence of speculative capital flight. In the long run, monetary policy can help lower domestic nominal interest rates by maintaining low inflation and dampening expectation about depreciation. The potential for reducing interest rates through monetary expansion is limited. Domestic inflation is partly a monetary phenomenon but structural factors also affect it. The effects of international inflation are immediate and strong; the effects of wage pushes are smaller and less immediate. Inflation can be reduced to some extent by slowing the growth of money - which strengthens the secondary influence of a slower crawling exchange rate. A managed float is appropriate for maintaining a competitive exchange rate, given the gap between world and domestic inflation caused by structural and monetary factors. Real depreciation of the exchange rate will be necessary to compensate for unanticipated decline in oil income (from lower than expected oil prices).