PUBPOL 542: Indonesia Presentation Indonesia 2000-2006: Walking the Fiscal and Monetary Policy...

PUBPOL 542: Indonesia Presentation

Indonesia 2000-2006: Walking the Fiscal and Monetary Policy Tightrope

Jonathan Haney, David Kase, Vishaal Rana

Public Policy 542


Executive Summary

Since the Asian financial crisis, Indonesia has made numerous economic strides including paying off its IMF debt and regaining GDP growth

Indonesia’s macroeconomic indicators suggest inflation, unemployment, and interest rates are high

Indonesia is highly dependent on oil exports, which can skew its macroeconomic data and adds risk to policy recommendations

Primary economic challenges for the country are:

1) Increasing GDP Growth

2) Reducing Inflation

3) Increasing income and service accounts in Current Account

The team recommends lowering taxes to stimulate growth and employment and tightening the money supply to reduce inflation


Macroeconomic Overview: Key Indicators

2002 2003 2004 2005 20062007

Target

Real GDP Growth

4.4% 4.7% 5.1% 5.6% 6.2% 6.0%

Inflation Rate 10.0% 6.8% 6.1% 10.5% 13.2% 6.2%

Unemployment Rate

9.1% 9.6% 9.9% 10.3% 12.6% N/A

Current Account

109,145 (5,397) 21,832 112,164 PositiveSlightly Positive

Interest Rate - - - - 9.75% 8.0-8.5%


Macroeconomic Overview: Selected Comparable Indicators

2002 2003 2004 2005 2006

Real GDP Growth

Indonesia 4.4% 4.7% 5.1% 5.6% 6.2%

ASEAN 4.8% 5.4% 6.1% 5.6% 5.8%

Inflation Rate

Indonesia 10.0% 6.8% 6.1% 10.5% 13.2%

ASEAN 7.3% 5.1% 4.8% 7.4% 8.1%

Interest Rate

Indonesia 13.6% 7.1% 6.7% 11.8% 9.7%

ASEAN 5.7% 5.3% 5.0% 5.7% 4.2%

Note: Interest Rate is 3 month time depositSource: ASEAN


Macroeconomic Overview: Government Spending and Tax Collection

Government is moving towards a balanced budget

High military spending compared to social services

Tax recovery rate has accelerated since financial crisis, but still below historical

Taxes as Percentage of Government Revenue

Revenues vs Expenditures


Major Issues in Indonesian Economy

GDP Growth

High unemployment is limiting the economy from operating at full employment

Recent GDP growth may be artificially buoyed by high oil prices

Inflation

While central bank has mandated inflation control, money supply has grown faster than inflation

Inflation expectations thus remain high

Current Account

Despite surplus, significant deficit in income and service accounts

Mineral (oil) exports prop CA and key trading partner is Japan


Zones of DiscomfortS

(ID

R/U

SD

)

Fiscal Ease (G↑ or T↓)

CA is slightly negative

(~500MM USD)

Economy is at full employment

Indonesia

• Excessive CA surplus

• Underemployment

●

Economic Production

Unemployment is currently at 12.6%

Underemployment is expected to be significantly higher

17% are living below the poverty line

Current Account

Given their developing economy, CA should be negative

However, Indonesia has a surplus and needs to plow that surplus back into economic growth


Output Market Equilibrium (DD schedule)A

ggre

gate

Dem

and

(D

)

Output (Y)

D = Y

Many avenues exist to drive up output; we choose tax rate decrease because:

Encourages growth by internal resources to meet additional demand

Entices other foreign direct investment to come into Indonesia

We do not expect a significant price increase to result

The country is operating below full employment, so wages shouldn’t increase

(t=12%)

(t=11%)

Y0 Y1


Current Asset Market Equilibrium (AA schedule)E

xcha

nge

Rat

e (S

)

Dom InterestRate (i)

Currently the real money supply is growing

Between 2000 & 2005, the money supply has grown by 74% and inflation has grown by 55%

This causes the exchange rate to “overshoot,” creating a much larger depreciation of Rupiah

The resulting reduction in exchange rate hasn’t occurred because the economy hasn’t returned to steady state or seen real money supply contraction

Rea

l Dom

estic

Mon

ey

Hol

ding

s (M

S/P

)

S0

S1

S2

%9.54

%9.73

P

M s

Interest rate parity curve shifts

outward due to expected inflation


Proposed Asset Market Equilibrium (AA schedule)E

xcha

nge

Rat

e (S

)

Dom InterestRate (i)

Our recommended steps work to pull down the real money supply.

As currency dries up, inflation will be put under pressure to reduce as the money supply contracts

Again, the currency will see a high initial appreciation followed by depreciation as prices adjust

Our concern is the effects that a tighten monetary policy will have on output (Y)

Rea

l Dom

estic

Mon

ey

Hol

ding

s (M

S/P

)

S0

S1

S2

%6

%4

P

M s

Interest rate parity curve shifts inward

due to expected appreciationS1

S2


Recommended Action Steps AA-DD Curve

Our action plan is a series of steps

1. Grow the economy through fiscal policy action (e.g., tax rate decrease)

Currency appreciates

Output increases

2. Tighten monetary supply through a real money supply contraction

Output decreases

Currency appreciates

3. Repeat the process

Strategy will have to change once country reaches full employment

Exc

hang

e R

ate

(S)

Output (Y)

DD0

AA0

Y0

S0

DD1

Y1Y2

AA2

DD3

Y3 Yf


Questions?

PUBPOL 542: Indonesia Presentation Indonesia 2000-2006: Walking the Fiscal and Monetary Policy...

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