Download Inflation and Monetary Policy in Indonesia: An Analysis of Key Determinants and more Slides Printing in PDF only on Docsity!
CHAPTER II
LITERATURE REVIEW
A. Theoretical Framework
1. Inflation According to Mankiw(2009), Inflation is an increase in the overall general price level of goods and services in the economy over a period of time, which constantly makes the purchasing power of the domestic currency is falling. However, inflation is not an easy thing to explained and control because this instrument of policy is potentially so powerful that can impact the economic conditions such as the society will face a short-run tradeoff between inflation and unemployment. Based on Law No. 3 of 2004, concerned in the effectiveness of monetary policy to achieve and maintain the stable value of rupiah rate, which the stability is shown through inflation rate and the exchange rate, the central bank of Indonesia called Bank Indonesia implemented an inflation targeting framework in order to keep the economy running smoothly. a) Based on the severity, inflation is divided into several categories:
- Creeping inflation, where the inflation is less than 10% per year.
- Galloping inflation, where the inflation rate is between 10- 30% per year.
- High inflation, where the inflation rate is between 30-100% per year.
- Hyperinflation, where the inflation rate is over 100% per year.
b) Based on the caused, the rising and falling inflation is caused by two factors:
- Demand -Pull inflation. Demand-pull inflation is inflation caused by the pull of demand or the rises in the aggregate demand for goods and that demand for expenditure is much bigger than the economy ability. This condition occurs when the production is in a state of full employment and inflation stems from their aggregate demand. In these circumstances, the increase in total demand will lead to the raising of prices may also increase production or output due to the rise of demand. If full employment can achievethe addition of the next demand then it will increase the price alone only. if the demand affecting the equilibrium of GNP at full employment then it will cause an "inflationary gap". An inflationary gap is what can cause inflation.
- Cost-Push Inflation Cost-push inflation is inflation due to the rise in production costs. The increase in costs production itself can be caused by several factors, including as a result of exchange rate fluctuation, international trading, government administration price, shocks in the supply side due to natural disasters and disruption of distribution by the central bank, monopolistic industry, and demand on increasing wage by unity trade unions.
Source: Karl E. Case, Ray C. Fair (2016) Figure 2-2 Cost-Push Inflation
From the curve above shows that the increase on the cost of production would move the supply curve and the axis of quantity to the left side while the demand remains the same eventually lead to the increase of price level. For
example in 2006 the price of Baltimore newspapers was 0.50 US Dollar and in 2007 the price is rising up to 0.75 US dollar due to the higher cost of production such as the price of ink, paper, and distribution, this condition shift the supply curve to the left and with downward-sloping curve of demand the price of Baltimore newspapers eventually rise (Karl E. Case, Ray C. Fair, 2016).
c) Based on the origin of occurrence, inflation is divided into two:
Domestic Inflation. Domestic inflation is usually caused by domestic causes, such as the printing of money to cover the deficit of government expenditure.
Imported Inflation. Imported inflation occurred because there is any international trade. If a country experiences inflation, this inflation can spread to other countries that have trade relations with them caused by their production of goods and services certainly will be sold more expensive.
Source: Mankiw(2011) Figure 2-3 Increase in the Money Supply
Based on the graph above, it is simply shown that the price level or the inflation rate would only change if the money supply and the money demand are on the imbalance conditions. Suppose the money supply is higher than the money demand would impact the rise in price level which leads to inflation. If the money supply is much lower than the money demand would impact to lower the price level which leads to deflation. In Utari, S and Pambudi(2015) book, The theory quantity of money based on Fisher formulas are: 𝑀 𝑉 = 𝑃 𝑌 Δ𝑀𝑠 Ms +
V =
P +
P =
Ms +
V −
Y
Where is : Δ𝑃P = Inflation rate. Δ𝑀𝑠Ms = Growth of Money Supply. Δ𝑉V = Percentage of the velocity. Δ𝑌Y = The output growth. Based on this theory can be concluded that the velocity of money is relatively stable or constant over the period. If the economic condition is assumed at full employment status which leads to Δ𝑌Y is equal zero. Then the inflation is known caused by the growth of money supply Δ𝑃P = Δ𝑀𝑠Ms
- Keynesian Theory Based on this theory, inflation appears because the aggregate demand is higher than the aggregate supply in full employment conditions (over the potential output). Such as, when the society wants to live the way more than what they can earn, this kind of situation generally leads to the inflation caused by the increase of great aggregate demand without followed by the supply. Another example based on Keynesian which can affect the price level is
structured caused, through monetary and fiscal approach. The unbalanced of economic conditions could be from domestics shocks (harvest failure, natural disaster) or anything related to international trade ( worsening in the term of trade, production rigidity, foreign debt, and the condition of the exchange rate) which can lead to the price fluctuation in the domestic market. According to Dornbusch and Fisher(2008),the impact of inflation on the economy is that inflation increase the high cost of holding currency lead on the decrease of demand for the currency, suppose this condition influencing the great mass of wealth redistribution between existing sectors such as from the private sector to the household sector then it will lead to another economic problem which is the increase in the number of poverty caused by the unemployment phenomenon, and increasing the real value of tax payments. In general, inflation had positive and negative effects depend on whether severe or not the inflation is. According to most economists if the inflation is mild then it has a positive influence to stimulate the economy by make people excited to work that can rise the national income. But it can be chaotic in the severe inflation or usually called by hyperinflation in this condition people
are not excited about working, saving and production because prices are rising rapidly and hard to bear.
e) Component of Inflation: Basically, inflation can be divided into two categories based on the cause of the occurrence. First is the Core inflation, and second is the Noncore inflation as displayed in the graph below.
Source: Utari et al (2015) Figure 2-4DisagregationInflasi
The core inflation or also called the underlying inflation is a measure of inflation that excludes certain items that have volatile price movements (fluctuate widely) on any given day which commonly cause shocks, such as volatile foods and administered prices from its considerations. The component of core inflation tends to persist in the inflation movement and influenced by the fundamental factors such as demand and supply, external factors
2. Money Supply Money supply is the quantity of money available in an economy. In an economy that uses fiat money, the government controls the money supply through a monetary policy with controlling the quantity of money printing, level of taxation, and the level of government purchases. In the United States the central bank called Federal Reserve shortened as Fed controls the money supply using monetary policy through decisions made by Fed’s Federal Open Market Committee, the open market operations are selling or purchasing the government’s bond to control the money supply. The works is if the government want to increase the money supply usually central bank would buy some government bonds from the public, with purchasing bonds from the public would increase the quantity of money in circulation, suppose the government want to decrease the money supply then central bank would sell some government bonds from its own portfolio. Changes in the quantity of money ( M ) when the velocity ( V ) is fixed will change the nominal of GDP ( PY ), with formula 𝑴𝑽̅ = 𝑷𝒀, therefore the quantity of money somehow can determine the national economy. Money supply divided into two categories based on the classification. The first is M1 which includes traveler’s checks, currency plus demand deposits, and other checkable deposits. M1 is generally more limited and liquid or easy to convert to physical currency. The second is M2 which is consists of M1 plus mutual fund balances, retail money
market, saving deposits (including money market deposits accounts), and short time deposit or can be written with formula 𝑀2 = M0 + M1 where M2 usually is less liquid and not easy to convert to physical money than M1. Even though M2 is never really used as payment but it often serve as a legitimate way to invest, increase wealth, pay bills, and taxes (Mankiw, 2009).
3. Exchange rates
There is any two component of exchange rates based on N. Gregory Mankiw(2011), the first is nominal exchange rate where the rate of a person can trade their currency to another currency from different country, the second is the real exchange rate, is where the rate of a person can trade a goods and services of one country to goods and services to another country. The relation between them is that the real exchange rate actually depends on the nominal exchange rate including the price of goods and services in both countries measured in the local currencies.
𝑹𝒆𝒂𝒍𝑬𝒙𝒄𝒉𝒂𝒏𝒈𝒆𝒓𝒂𝒕𝒆 = 𝑵𝒐𝒎𝒊𝒏𝒂𝒍𝒆𝒙𝒄𝒉𝒂𝒏𝒈𝒆𝒓𝒂𝒕𝒆 × 𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄𝒑𝒓𝒊𝒄𝒆𝑭𝒐𝒓𝒆𝒊𝒈𝒏𝑷𝒓𝒊𝒄𝒆
Based on Ito (2007), some of East Asia such as Korea, Thailand, Indonesia, and the Philippines are adopted an Inflation Targeting system around 1998, and some of them are have not necessarily given up on
multiplier and accelerator effect within the circular flow of income and spending. This phenomenon is already proved by economists at Goldman Sachs t that one percent fall in the domestic currency value will give the same result on the output of economy by 0.2 percent.
4. Interest rate There are any two categories of interest rate, the first is the nominal interest rate which is published or quoted interest rate on a financial asset. The second is the real interest rate which is a return to the investor measured in terms of its actual purchasing power. The interest rate in Indonesia is controlled by the central bank called Bank Indonesia, shortened BI. The rate is announced by the Board of Governors of Bank Indonesia monthly and implemented in the operation of monetary policy as an effort to achieve the operational and economic stability. Since Bank Indonesia officially implemented Inflation Targeting Framework (ITF) in full on July 2005 they change its operational final target monetary policy from amount of money (base money / M0) which is known as inflation targeting framework lite to the full-fledged inflation targeting framework with the announcement of interest rate (the BI Rate) in monthly basis as a target operational with the power through monetary policy that the central bank has. Since 2003, the change of interest rate becomes more dominant than money supply in the monetary stability, especially the interest rate that formed at each SBI auction is carried out
(the determination of discount rate). The central bank declares that the rise in the interest rate could suppress public and government spending so as to reduce the overall demand which ultimately decreases the inflation, on the other hand, interest rates also could strengthen the exchange rates through positive interest rate differential (M, Guruh and R, 2008). Looking at the quantity theory of money which determines the inflation, where is if the money supply is growing the prices tend to rises, the conditions of interest rate when its low will increase the money supply because individuals and businesses tend to demand more loans (money to spend) resulting the economy to grow and inflation to increase. When the conditions of interest rate are high, consumers tend to save their money more decreasing the circulation of money in the society which leads to the economic conditions to slow down and the inflation rate to decrease.
5. Gross Domestics Product Gross domestics product is the total market value of all final goods and services or output produced within a given period of time by factors of production located within a country. GDP can be computed in two ways, one is the expenditure approach where the total amount spent on all final goods and services or consumption together with investment, government expenditure, and net exports during a given period adds up, GDP= C+I+G+(EXP – IMP), and second is the income approach where the income, rent, interest, and profits received by all production factors in
level. The policy called expansionary policy eventually will shift the aggregate demand to the right side, allowed the output to increase which calm down the price level and inflation rate (Karl E. Case, Ray C. Fair, 2016).
6. The correlation Between Money supply and Inflation The relationships between money supply and inflation are has been explained above. Which is higher the money supply caused by either printing or buying a legitimate certificate or bonds from the public could lead to the inflation is supported in the theory monetarist or also called the quantity theory.
Source: Mankiw (2011) Figure 2-5 Increase in the Money Supply
On the graph above shows that when the government increases the money supply from MS1 TO MS2, The value of money becomes lower, and the price level (on the right axis) is become higher, which means that each money becomes less valuable to buy goods and services. Short in the chase, based on the quantity theory, the growth rate in the quantity of money available in society determines the value of money, and the growth rate in the quantity is the cause of inflation (Mishkin and Eakins, 2003).
Source: Karl E. Case, Ray C. Fair (2016) Figure 2-6 Liquidity of Money to the Economy
The curve above explained that the money supply can become a monetary tool to solve a certain conditions in the economy through its monetary policy. Suppose the economic condition of a nation is sluggish, then through the expansionary monetary policy with rise the money supply from LM1 to LM2 eventually will increase the income of society and
