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Chapter 2

EVALUATING MONETARY TRANSMISSION MECHANISM ININDONESIA USING A STRUCTURAL FAVAR APPROACH1

ByLinda Nurliana2

Rizki Ernadi Wimanda3

Redianto Satyanugraha4

1. Introduction

The monetary transmission mechanism is the process through which monetarypolicy decisions affect the economy in general and the price level in particular(ECB, 2015). Understanding how monetary policy affects the economy is essentialfor the central bank. To be able to design and implement its monetary policyproperly, policymakers must have an accurate assessment of the timing andeffects of their policies on the economy. To make this assessment, they needto understand the mechanisms through which monetary policy impacts realeconomic activity and inflation (Boivin et al., 2010).

Monetary policy works largely via its influence on aggregate demand in theeconomy. Nevertheless, the precise nature in which monetary policy is transmittedto the economy and price level is not easily determined as different channelswork simultaneously with long, varying and uncertain time lags. Furthermore,the liberalization of trade, investment, and financial transactions can also haveimpacts on the transmission of monetary policy.

The monetary policy objectives or framework adopted in a country is closelyrelated to the structural adjustment, degree of financial development, and the

________________1. The authors are thankful to Dr. Solikin M. Juhro for his input and suggestions for this

study. The authors also wish to thank Mr. Wiweko Junianto who assisted in data collection.The views in this paper are those of the authors and do not solely reflect the views ofBank Indonesia or The SEACEN Centre. Errors and omissions are sole responsibilities ofthe authors.

2. Economist, Economic and Monetary Policy Department, Bank Indonesia.

3. Division Head, Economic and Monetary Policy Department, Bank Indonesia.4. Economist, Economic and Monetary Policy Department, Bank Indonesia.

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macroeconomic settings in which the monetary policy is implemented. In thecase of Indonesia, some structural adjustments in economic sectors have occurredin the last few decades. The changes are strengthened by the faster pace inglobalization and the financial crises of 1997/1998 and 2008/2009. Theseadjustments have major implications for monetary management and thetransmission mechanism of monetary policy.

A major change in the conduct of monetary policy in Indonesia in theaftermath of the 1997– 2000 crises was the enactment of Act No. 23/1999 andits revision, Act No. 3/2004. The Act gives Bank Indonesia the single objectiveto achieve and maintain the stability of the rupiah. Bank Indonesia is also grantedindependence in formulating and implementing monetary policies. To achievethe objective, Bank Indonesia adopted a full-fledged inflation targeting framework(ITF) in July 2005.

The global financial crisis (GFC) in 2008/2009 also had an impact on monetarypolicy management in Indonesia. The GFC provided a lesson for central banksthat while price stability should remain the primary goal, maintaining low inflationalone, without preserving financial stability, is insufficient to achievemacroeconomic stability (Juhro, 2014). The dynamic capital flows to emergingmarket like Indonesia also offers challenges for monetary policy implementation.More flexibility is required for monetary authorities to manage capital flows inthe form of policy mixes between monetary and macroprudential policies.Furthermore for a small open economy like Indonesia, there is a case for managingthe exchange rate to avoid excess volatility. Exchange rate and capital flowmanagement play important roles in the inflation targeting framework in Indonesia.

The financial sector is also changing in Indonesia. The capital market asrepresented by the market capitalization/GDP ratio grew by 50% and the stockprice index grew by 337% in the last decade (June 2005 to June 2015). Althoughthe banking sector still dominates financing activities in Indonesia, the changingfinancial landscape also raises questions as to whether monetary transmission,especially through the banking channel or asset channel, has changed.

There have been many studies conducted in Bank Indonesia to assess themonetary transmission mechanism. The studies mainly use VAR and SVAR toevaluate whether monetary policy is transmitted in each channel. To complementthe previous studies, the objective of this paper is to reinvestigate the effectiveness

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of the monetary policy transmission in all the channels and identify the relativeimportance of the channels using Structural Factor-Augmented VAR (SFAVAR).

Factor-Augmented VAR (FAVAR), proposed by Bernanke, Boivin and Eliasz(2005) combines standard VARs with factor analysis to exploit large data sets.This approach allows a better identification of the monetary policy shock as itenables the use of unlimited variables to proxy theoretical constructs, such asthe real activity, inflation and others. FAVAR thus eliminates the necessity ofarbitrarily choosing a specific variable to represent an economic concept.Furthermore, with the flexibility of using many variables, this approach allowsthe study of all the channels and measure the relative importance of eachtransmission channel. We believe this research would contribute to the existingresearch on monetary policy transmission in Bank Indonesia.

The rest of the paper is organized as follows. Section 2 discusses themonetary policy and operations in Indonesia and assesses the transmissionmechanism of monetary policy through various channels. The literature reviewis presented in Section 3. Section 4 discusses the methodology and data usedin the empirical study. The empirical findings are discussed in Section 5 whileSection 6 concludes the study.

2. Overview of Monetary Policy and Monetary Transmission

2.1 Overview of Monetary Policy Framework in Indonesia

Bank Indonesia was established in 1953 following the nationalization of theJavasche Bank NV and further regulated by the Central Bank Act Number 13of 1968. Under the said Act, Bank Indonesia had multiple objectives of maintainingprice stability and stimulating economic growth and employment. Bank Indonesiaalso served as a development bank.

During this time, Indonesia adopted foreign exchange controls under ActNo. 32/1964 on Foreign Exchange Regulation. Under this regulation, foreignexchange obtained from natural resources and business operations in Indonesiais controlled by the state. Consequently, exporters must sell foreign exchangefrom their export proceeds in foreign exchange banks, which were subsequentlysold again to Bank Indonesia. Also, residents and firms are required to registerand store foreign-currency securities or bonds in government foreign banks.This policy, on the one hand, was quite successful in isolating the national economyagainst external influences, but on the other hand, created a black market forforeign exchange.

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Therefore, since 1967, the stringency of the exchange controls was graduallyreduced through Act No. 1/1967 on Foreign Direct Investment (FDI). The purposeof this Act was to attract capital inflows to finance domestic investments. In1970, the government declared the rupiah a fully convertible currency (free foreignexchange regime), with no restrictions on the flow of foreign exchange into orout of Indonesia. Credit reform began in 1983 when the artificial restrictions onbank credit and the state bank interest rate were eliminated. Bank Indonesiareduced its significant role in refinancing bank loans and introduced Bank IndonesiaCertificates (SBI) and money market securities which were issued and endorsedby banks. Subsequently, Bank Indonesia adopted indirect monetary policy toreduce the supply of reserve money, under which monetary policy transmissionis viewed to run from monetary base (operating target) through monetaryaggregate (intermediate target) to output and inflation (ultimate target).

Financial sector reform was taken further in 1988 when restrictions on theoperations of foreign banks were eased, and the procedures for establishingbranch banks were simplified. The bank reserve requirement was loweredsuccessfully, reducing the spread between borrowing and loan rates. The re-utilization of the reserve requirement as an indirect instrument of monetary policyis intended to control bank credit in the light of the surge in capital inflows.

The economic and financial crisis in Indonesia in 1997 resulted in the worstrecession the economy had ever experienced. One outcome was that theGovernment finally allowed the exchange rate to float freely in mid-August 1997.A major change in the conduct of monetary policy in the aftermath of the crisiswas the new Bank Indonesia Act that gives the Bank full autonomy in formulatingand implementing policies. Under this Act, Bank Indonesia has a single objectiveto achieve and maintain the stability of the rupiah (currency) value, meaninginflation and exchange rate. The Act also grants independence for the centralbank in both setting the inflation target (goal independence) and conducting itsmonetary policy (instrument independence). After the amendment of the CentralBank Act of 1999, the new Act in early 2004 states that the inflation target isset by the Government, in consultation with Bank Indonesia. This stipulationimplies that in conducting monetary policy, Bank Indonesia has only instrumentindependence and no longer goal independence.

Implicitly, the Act mandates the central bank to implement the monetarypolicy framework based on interest rates replacing the previous monetarytargeting. The monetary targeting is considered no longer suitable for thedevelopment of the financial market, especially after the crisis period. The mostdominant change is the increasingly important role of interest rates, compared

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to the money supply, to monetary stabilization. The rapid development andinnovation in the financial markets, the integration of the domestic financial marketwith the global market, as well as the development of financial market instrumentsthat are sensitive to interest rates such as bonds and mutual funds contributeto the changes in the role of interest rate. Because these factors, Bank Indonesiaadopted a full-fledged inflation targeting framework (ITF) in July 2005 (Goeltom,2008). With the ITF, the inflation target is the overriding objective and nominalanchor of monetary policy. In this regard, Bank Indonesia will apply a forward-looking strategy to steer present monetary policy towards the achievement ofthe medium-term inflation target.

The inflation targets are set by the Government in coordination with BankIndonesia. For 2015-2017, the Government has set the CPI inflation target at4% with a deviation of ± 1% and for 2018, the target is 3.5± 1%. These targetsare consistent with the process of gradual disinflation towards a medium- tolong-term inflation target of around 2-4%, comparable to other economies.

The BI rate is the policy rate that is used to convey the monetary policystance. This rate is determined in monthly meetings of the Board of Governorsand announced openly to the public. The monetary policy stance would consistof change or no change of BI Rate. The BI rate is translated into the operationaltarget - the overnight interbank money-market rate (O/N interbank rates).

The monetary operations aim to keep the movement of O/N interbank ratesaround the BI rate. If movements in the overnight interbank rate do not deviatefar from the anchor (the BI rate), Bank Indonesia will work consistently tosafeguard and fulfil the liquidity needs of the banking system while maintainingthe equilibrium for formation of fair, stable interest rates.

The operational target is attained by monetary operation through OpenMarket Operations (OMO) and the Standing Facility. Activities of OMO consistof the issuance of Bank Indonesia Certificates (SBI), repo and reverse repotransactions, term deposits, securities trading, and intervention in the foreigncurrency market. Eligible assets for repo and reverse repo transactions are SBIand Government Securities. The Standing Facility consists of the lending facilityand deposit facility.

The full implementation of the monetary policy framework with the BI rateas the target for O/N interbank rates started on 9 June 2008. However, sincethe third quarter 2009, the implementation faced new challenges. The monetaryeasing measures by the Fed. Reserve resulted in surges of capital flows into

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emerging markets, including Indonesia. Consequently, the pressure of exchangerate appreciation and overshooting of financial asset prices could not be avoided.The decision to cut the BI rate was insufficient to withstand the rapid capitalinflows. To mitigate these risks, Bank Indonesia sterilized the market by increasingthe accumulation of foreign exchange reserves, on the one hand, and adding tothe excess liquidity and increases the monetary burden, on the other.

Bank Indonesia responded to the situation by modifying the monetaryoperations since October 2010. Since that period, Bank Indonesia maintains anasymmetrical corridor and, as a result, the O/N interbank rates tend to movecloser to the Deposit Facility rate (Figure 1).

2.2 Main Monetary Policy Transmission Channels in Indonesia

The financial structure in Indonesia is more bank-oriented than capital marketoriented. The banking system dominates 70-80% of assets in the financial system.Bank credit also dominates financing activities to the amount of US$ 40.74 bnor a share of 83% in 2014 (Figure 2). In terms of outstanding credit (Figure 3),the ratio of bank credit in 2014 was approximately 74.12%, which is higher thanthe previous year (73.17%) and the 4-year average (71.59%). The increasingshare of credit banking is mainly due to slow growth of financing from thebonds market and Non-Bank Financial Institution (NBFI) credit.

Figure 1Policy Rate and O/N Interbank Rate

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Figure 2Financing Activity (Flow in US$ bn)

Figure 3Financing Structure (Position %)

Given the dominance of banking system, the interest rate and banking lendingchannels are assumed to play important roles in monetary transmission. Underthe ITF era, transmission mechanism through the interest rate channel appearsto work. As shown in Figure 4, the BI rate movement is followed closely bythe Indonesia Deposit Insurance Corporation (IDIC) rate. The 1-month depositrate and the loan rate also appear to follow the BI rate. Credit growth seemsto respond to the loan rate. As the loan rate increases, credit growth is slowingdown (Figure 5).

The money and credit growths appear to follow a similar pattern and haveimpacts on inflation (Figure 6). The average duration impact of M1 growth oninflation is 5-6 quarters, and credit growth to inflation is around three months

Figure 4Bank Interest Rate and

Policy Rate

Figure 5Loan Rate and Credit

Growth

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(Juhro, 2010). In a small open economy like Indonesia, the exchange rate alsohas an important role in transmitting monetary policy, in that exchange ratemovements significantly influence the development of aggregate demand andsupply, and thus output and prices. As shown in Figure 7 before the GFC, therewas a significant pass-through effect of the exchange rate to inflation implyingthat depreciation leads to inflation, but the impact appears to have weakened inrecent periods.

We also conduct event analysis to see whether the market rates respondto a monetary policy shock. Figure 8 depicts the response of the differentmaturities of deposit rates following the 25-bp increase of BI rate in the year2005-2014. There are 12 episodes of 25-bp BI rate increase in the year 2005-2014. The lines in the graph depict the average of the deposit rates at fouroccasions namely the day of the Board of Governors’ (BoG) meeting, one dayafter BoG, seven days after BoG, and a day before the next BoG. The bluepanel is the difference between the deposit rate of 1 day before the next BoGand on the day of BoG.

Following the increase of the BI rate by 25-bps, the deposit rates alsoincrease during the absorption period where the rates keep increasing until oneday before the next BoG meeting. The blue panels show that the increase indeposit rates is smaller for the longer maturity of deposits. Government bondsalso show a similar response as can be seen in Figure 9. For different maturitiesof government bonds, the yields increase following the BI rate increase. Theyields keep increasing until the day before the next BoG meeting. This analysisshows that the monetary policy appears to be transmitted to the banking andcapital market.

Figure 6Monetary Aggregates and

Inflation

Figure 7Exchange Rate and

Inflation

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3. Literature Review

There have been several studies on monetary transmission in Indonesia. Astudy by Warjiyo and Agung (2002) compiled the research for every transmissionchannel conducted in early 2000. Goeltom (2008) summarized the same studieswith several additional research conducted after 2002. Further studies in 2009and post-GFC usually focused on specific channels to answer specific questions.

The studies usually use VAR/SVAR methodology to account for endogenousrelationships and summarize the empirical relationships without placing too manyrestrictions on the data (Berkelmans, 2005). While a SVAR model is compatiblewith many different economic theories, the estimates can be sensitive to theset-up of the model. Previous studies using SVAR usually employ different setsof variables in the model and thus a comparison between the studies is not easy.Furthermore, the study of the individual or specific channel does not allow theidentification of the relative importance of the transmission channels. Thisinformation is relevant given the change in the economy and financial system.For example, a growing capital market and surging capital inflows could implythat the asset price channel is stronger than before (Tahir, 2012). Another situationis when the foreign banks’ share of the domestic financing is dominant. Thissituation may imply that the bank lending channel could be weaker as foreignbanks are less affected by the domestic monetary policy. The information ofrelative importance of the channels is naturally relevant for the central bank inits design of monetary operations and effective implementation of monetary policy.

Figure 8Bank Deposit Rates

Figure 9Government Bond Yields

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In general, all studies find that the interest rate and credit channels appearto work in Indonesia. The exchange rate channel was very weak before the1997 crisis because the monetary authorities’ action to maintain exchange ratevariability within a certain band, which had kept the exchange rate relativelystable and predictable. Post-1997, the exchange rate channel appears to workin transmitting monetary policy, but in the aftermath of GFC in 2008/2009, thechannel does not appear to respond as strongly. For the asset price and inflationexpectation channels, early studies reveal little evidence of their presence,although more recent studies have started to find evidence of their existence.

3.1 Interest Rate Channel

Studies about the interest rate channel typically analyze the first stage oftransmission by determining the way the policy rate affects loan and depositrates. The next stage of determining whether the interest rate would affectinvestment or consumption would depend on the purpose of the study and thevariables they use in the model. Some studies include economic activity variablesand try uncover whether the policy rate affects target variables such asinvestment, consumption, and inflation. Other studies do not include the targetvariables in their specification and assess only the interest rate transmission.

Kusmiarso et al. (2002) study the interest channel for the period from January1989 to December 2000. They divide the study into the pre- and post-1997crisis. Empirical evidence from the VAR analysis reveals that before the crisis,the transmission channel appears to work effectively. The real deposit rate andinvestment credit rate were strongly influenced by the interbank rate. However,the rates do not appear to have any impact on investment and consumption.Investment growth was influenced more by the high access to foreign borrowingthan the real investment credit rate. After the crisis, the transmission channelappears to be less effective than before. The responses of the real deposit rateand real investment credit rate to the interbank rate were weaker than thosepreviously. However, investment growth has been significantly influenced by thereal investment credit rate since investors have limited access to other sourcesof financing. Using the least square methodology, Kusmiarso et al. (2002) identifiedthe determinants of the interbank, deposit and loan rate. The result is that SBIrate is significant in explaining the interbank rate. Subsequently, the interbankrate is significant in explaining the deposit rate, and the deposit rate is significantin explaining the loan rate. This finding implies that the interest rate channelappears to work. The result is supported by the survey of banks, companies,and households which reveal that banks and companies have a significantresponse to substantial changes in policy rates.

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Dewati, Suryaningsih and Chawwa (2009) investigate the interest channelusing VAR with data from 2000q1 to 2009q1. Their result is similar to Kusmiarsoet al. (2001) which asserts that an increase of the BI rate will cause loan ratesand deposit rates to increase. Consumption seems to be affected by the depositrate, although investment does not seem to be affected by real loan rates. Theyalso employ panel data to study the determinants of bank loan rates. Usingindividual bank data from January 2002 to April 2009, they find that the BI ratesignificantly affects loan rates, implying that the interest channel works.Furthermore, they find banks with higher assets, liquidity and capital tend to beless responsive to a change in the BI rate.

Another study by Wimanda et al. (2013) investigates the interest rate channelin the aftermath of GFC. The study attempts to answer the question as to whethera modification in monetary operations where the interbank rates move closer tothe deposit facility rate than to the BI rate, has any impact on the monetarytransmission. Employing VAR for data from July 2005 to April 2013, the studyfinds that the interbank, IDIC5, deposit and loan rate, increase in response toan increase in BI rates. This finding confirms the first-stage transmission frompolicy rate to banking interest rates. Further investigation by using the GrangerCausality test finds that the policy rate is transmitted to the banking rate throughthe IDIC rate and not through the interbank rate.

Similar to Wimanda (2013), Juhro et al. (2014) try to identify the transmissionof the BI rate to the banking rate after the GFC. Using monthly data from July2009 to June 2013, they derive a similar result to Wimanda (2013) where thetransmission of the BI rate to deposit and credit rate is through the IDIC rate.The policy rate (as represented by the deposit facility rate) plays a role in theexchange rate channel, serving as a signal of monetary management (liquiditymanagement). The increase of the deposit facility rate can affect the overnightinterbank market and influence financial market indicators, namely, the yield ongovernment bonds. The increase in government bond yields would cause aappreciation in the exchange rate, influencing the inflation rate.

A study using FAVAR by Harahap et al. (2013) find that the interest ratechannel appears to work, with an increase in the BI rate causing significantincrease in the loan and deposit rates as well as government bond yield.

________________5. Indonesian Deposit Insurance Corporation.

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3.2 Credit Channel

The credit channel appears to transmit monetary policy even though theintensity varies across time. Pre-1997 crisis, bank lending was almost unaffectedby monetary policy but post-crisis, there was a discernible impact. The studiesalso identify the balance sheet channel, where monetary policy affects the firms’balance sheets and external financing costs which finally impact the investmentactivity of firms.

3.2.1 Bank Lending Channel

Agung et al. (2002) study the credit channel using monthly data from January1991 to December 2000. The results from VAR analysis show that bank lendingin the pre-1997 crisis period was almost unaffected by monetary policy as theaccess of domestic commercial banks to international sources of funds wasrelatively easy. Post-crisis, however, the study reveals a “credit crunch” wheretight money policy exacerbated the unwillingness of banks to lend. This resultis supported by another finding using the VECM approach. In the short-run, thecredit market is more dominated by supply rather than demand. They also usepanel data to investigate the determinants of bank lending. They find that pre-crisis, the policy rate does not seem to affect bank lending but post-crisis, banklending is significantly affected by monetary policy. The sensitivity of lending tothe policy rate increases for banks with low capital. This result is also supportedby the bank survey that finds that the majority of banks will reduce the loansupply in the case of tight money policy. This finding is especially true for banks,which have limited access to other sources of funds.

Dewati, Suryaningsih and Chawwa (2009) employed VAR and panel datato study the bank lending channel for the period 2000q1 to 2009q1. They findthat an increase in the Bank Indonesia Certificate rate would reduce crediteven though lower credit does not seem to affect investment growth. Usingpanel data of individual banks from 2002 to 2009, they find that the policy rateis significant in explaining bank lending. Similar to Agung et al. (2001), thesensitivity of bank lending to the policy rate decreases as the bank’s asset, liquidityor capitalization increases.

Another study by Wimanda et al. (2013) using VAR for data from 2006 to2013 is also supportive of the existence of the credit channel. The study concludesthat BI rates can affect aggregate demand through bank lending as the banks’credit-to-asset ratio decrease to a positive shock of the BI rate. This finding issimilar to Juhro et al. (2014) who find a BI rate hike cause the credit gap and

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inflation to decline. Harahap et al. (2013) using FAVAR also finds the existenceof a credit channel, although post-GFC, the impact is not as strong as the previousperiod due to the excess liquidity.

3.2.2 Balance Sheet Channel

The study on the balance sheet channel using individual firms’ data wasfirst conducted by Agung et al. (2002). They use data from 219 non-financialcompanies listed on the Indonesian Stock Exchange for the period 1992-1999.The study attempts to answer two questions - first, whether a firm’s balancesheet indicator affects a firm decision to invest. Then they try to answer thequestion of whether monetary policy affects the sensitivity of firms’ investmentto the balance sheet indicator. For the balance sheet indicator, they use variablesof cash flows, total debt and short debt ratio. Their study finds that that thebalance sheet indicator affects the firms’ decision to invest. For the secondquestion, they find that during the tight monetary policy, the sensitivity ofinvestment to balance sheet indicator (total debt and short debt ratio) increases,implying that tight monetary policy cause firms to face a premium cost for externalfinancing. Thus, firms find it more difficult to obtain external financing, thusaffecting their investment. This finding proves the existence of a balance sheetchannel although no clear evidence was found for financially constrained firmsto be more affected by monetary policy than large firms, as predicted by thetheory.

A recent study of the balance sheet channel is conducted by Wimanda etal. (2014), using data of 185 non-financial companies listed on the Jakarta StockExchange from 2000 to 2013. The empirical results show that the balance sheetchannel transmits monetary policy, in particular, through companies that havefinancial constraints. The coefficient of the balance sheet indicator (cash flow,total debt and short debt ratio) for small firms becomes more sensitive to tightmonetary policy, implying that the reliance on internal funds for investmentincreases as external funds become scarce. The opposite is true for loosemonetary policy with investment becoming less sensitive to internal funds as thepremium cost of external financing decreases, and easier access to externalfunds.

3.3 Exchange Rate Channel

Siswanto et al. (2002) conduct a study on the exchange rate channel usingmonthly data from January 1990 to April 2001. The study employs SVAR, whichseeks to detect the transmission of exchange rate changes on the inflation rate

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both directly, through price (direct pass-through effect), and indirectly, throughthe output (indirect pass-through effect). The findings from the SVAR analysisreveal that during the pre-1997 crisis period, monetary policy transmission throughthe exchange rate channel was very weak. Monetary authorities’ action tomaintain exchange rate variability within a certain band has kept the exchangerate relatively stable and predictable. Under such conditions, the interest rate onthe SBI instrument did not have a significant impact on the exchange rate, andthe exchange rate was not an important determinant of inflation. Post-crisis, thestudy finds that direct pass-through effect of the exchange rate to consumerprices is larger than the indirect, implying that an appreciation of the exchangerate will boost GDP. This finding is in contrast to the expectation where anexchange rate appreciation could make exports less competitive and contractGDP. The relatively high pass-through effect of the exchange rate on the domesticeconomy is caused by the high import content of capital goods and raw materialsin investment and production activity, as well as to the considerable amount ofexternal debt. Also, the appreciation of the exchange rate could generate higherGDP growth through indirect pass-through as an appreciation will encourageconsumption and investment. Indeed, at a certain level, an exchange rateappreciation would support exports of manufacturing products with high importcontent.

A recent study by Harahap et al. (2013) using FAVAR finds the existenceof the exchange rate channel where the increase of the policy rate is followedby the appreciation of Rupiah, although the impact after the GFC in 2008/2009is less responsive compared to previous periods. Juhro et al. (2014) find that theexchange rates channel transmits monetary policy through the policy rate’s impacton the financial market indicator such as government bond yields.

3.4 Asset Price Channel

Idris et al. (2002) analyze the asset price channel using monthly data fromJanuary 1989 to 2001. Employing SVAR and using stock prices as a proxy forasset prices, they find little evidence of the asset price channel. They suspectthat the absence of the channel owes to the use of stock prices as a proxy forasset prices, as the Jakarta Stock Exchange (JSX) index cannot properly reflectthe wealth of the economy. This finding is similar to the study by Dewati,Suryaningsih and Chawwa (2009). Employing VAR with quarterly data from2000 to 2009, they find that a monetary policy shock does not seem to affectthe asset price proxied by stock and property prices. A study by Harahap et al.(2013) also finds that before the Inflation Targeting Framework (ITF) (or before

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2005), the asset price channel does not seem to transmit monetary policysignificantly.

3.5 Expectation Channel

The study on the expectation channel was first conducted by Wuryandaniet al. (2002). Using monthly data from July 1997 to December 2000, the analysiswith SVAR reveals that there is monetary transmission through the expectedinflation channel. The inflation expectation itself is mainly determined by theexchange rate, past inflation (inertia), and the interest rate. The result confirmsthat expected inflation plays a role in inflation formation although it is not asstrong as other variables such as inertia (past inflation). The significant effectof past inflation indicates that monetary authority credibility is factored in whenforming the expectation. In turn, the credibility will determine the effectivenessof inflation targeting. This finding is similar to the study by Dewati, Suryaningsihand Chawwa (2009) which finds that inflation expectation is backward lookingbecause the actual inflation influences it. The inflation expectations have asignificant effect on inflation, but not on domestic demand. The VAR impulseresponse shows that there is no significant impact of a SBI shock on inflationthrough this channel. A recent study by Harahap et al. (2013) finds the existenceof an expectation channel, where a monetary shock appears to have an effecton the inflation expectation.

4. Data and Research Methodology

4.1 Methodology

VAR models are widely used to identify and examine the impact of monetarypolicy innovation on macroeconomic variables. The VAR approach hasadvantages in its ability to produce a credible empirical response ofmacroeconomic variables to monetary policy without having to apply an excessiverestriction on the dynamic structure of the model (Soares, 2011). However, VARis a small-scale model with a limited set of information. Bernanke et al. (2005)argues that VAR models rarely used more than 6 to 8 variables. Thus, thenumber of variables that can be included in the VAR model is unlikely to representthe whole set of information monitored and used by the central bank whenformulating policy. Eliminating a lot of relevant information in the analysis ofVAR has a risk of omitted-variable which can lead to biased estimates of VARcoefficients. Furthermore, the limited number of variables can cause the selectionof variables to represent the economic concepts, seem arbitrary.

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Based on the above-mentioned problems, Bernanke et al. (2005) proposedthe Factor-Augmented VAR (FAVAR) which combined standard VARs withfactor analysis to exploit large data sets in the study of monetary policy. Researchon the dynamic factor model argues that the information contained in a largedataset can be summarized in a small number of “latent” factors. Bernanke etal. (2005) argues that if the factors can effectively summarize information fromthe large data, then the natural solution to the problem of degree of freedom inthe VAR analysis is to use a factor in the VAR model. FAVARs allow a betteridentification of the monetary policy shock as it permits the use of unlimitedvariables to proxy theoretical constructs, such as the real activity, inflation, andothers. This approach thus eliminates the necessity of arbitrarily choosing aspecific variable to represent an economic concept. FAVAR also allowsresearchers to compute impulse responses for hundreds of variables.

The shortcoming, however, is that the factors are not identified and, therefore,lack any economic interpretation (Belvisio and Milani, 2006). They propose toset restrictions in the formation of factors so that it is possible to attribute theeconomic interpretation to the common factors. For example, the inflation factoris only formed by the inflation variables while real activity is only formed by theGDP or industrial production data. This approach ensures that the factor formedhas economic meaning.

The original FAVAR model has the following structure. Let Yt be a M x 1vector of observed economic variables and Ft a K x 1 vector of unobservedfactors which captured most of the information on Xt and represent genericeconomic concepts like “economic activity” or “inflation”. According to Bernankeet al. (2005), the dynamic relationship (Ft, Yt) can be represented by the followingequation:

(1)

where Φ (L) is an order-d polynomial that has the usual restrictions present anderror vt term with zero mean and covariance matrix Q. If the coefficients ofΦ (L) in (1) that link Yt and Ft-1 are equal to zero, then this system reduces toa standard VAR in Yt; otherwise, the system expressed in (1) is a VAR in termsof (Yt,Ft) or as Bernanke et al. (2005) label it, a factor-augmented vectorautoregression (FAVAR).

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Since the factors are unobservable, Equation (1) cannot be estimated directly.However, once the factors interpreted as forces that affect many economicvariables, factor model techniques allow them to be inferred indirectly througha dataset of an observed series. Let Xt be a N x 1 vector containing observedeconomic variables (usually called the informational series), with N beingsufficiently large (at least larger than the number of periods T, and much largerthan the number of factors K + M << N). Bernanke et al. (2005) propose thatthe non-observed factors Ft can be related to the informational series throughoutthe following observation equation:

Xt = Λf Ft + ΛyYt + εt (2)

where Λf is a N x K loading matrix, Λy is a N x K matrix of coefficients, andεt is a N x K error vector with a zero mean.

According to Equation (2), the series in Xt can be interpreted as stochasticmeans of the factors contained in Ft conditioned on Yt which can also includelags in the fundamental factors. Because of that, this equation without theobserved factors Yt is referred as a dynamic factor model.

The contribution of the FAVAR model given by Equations (1) and (2), is asBernanke et al. (2005) emphasize - if central banks and the private sector hadinformation beyond that included in the VAR, the measurement of the unsystematicpart of monetary policy would be incorrect. FAVARs allow a better identificationof the monetary policy shock, since they employ a more realistic information setand permit observation of impulse responses for shocks on all the economicseries included in the factors.

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(3)

(4)

With the above set of restriction, if the vector is divided into subsets ofvariables that have the same “economic concept”, the common force that driveseach subset now has an economic meaning. For example, the common factorbuilt from the variables like industrial production, sales index, and capacityutilization can be interpreted as the factor of “economic activity”.

To estimate the SFAVAR model as outlined in the system of Equations (3)and (4), Bernanke et al. (2005) present two different strategies, namely, a Bayesianestimation approach and a two-step procedure based on Principal ComponentAnalysis (PCA). The Bayesian approach has the benefit of accounting for thestructure of the transition equation in the estimation of the factors. However,the computation of this approach is more complicated, and it does not seem tohave a meaningful or practical advantage. Belviso and Milani (2006) show thatboth methods generate highly correlated factors, while Bernanke et al. (2005)state that some outcomes from the Bayesian estimations are at odds witheconomic theory.

This study follows Bernanke et al. (2005) and Fonseca and Pereira (2014)which employ a two-step approach with PCA. Based on the two-step approach,the first step is to estimate factors which are the first principalcomponents obtained from each group of a series that forms an economicconcept. The second step, the estimated factors are used within the VARrepresented by Equation (3) to estimate Φ(L).

To derive the objective of this study, we construct a structural form model.Structural VAR is a multivariate, linear representation of a vector of observablevariables on its lag. These models are called structural because of their economicinterpretation. In these models, the identification restrictions are used accordingto some economic theory that use the non-recursive structure while still imposing

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restrictions only on contemporaneous structural parameters. We employ theImpulse Response Functions (IRF) to give the visual representation of thebehavior of observed series in response to a structural shock. The IRF alsoallows the computation of the forecast error variance decomposition that can beused to rank the monetary transmission channels according to their relativeimportance (Tahir, 2012). The variable that explains larger variations in the targetvariables such as GDP and inflation will be ranked higher and assumed as moreimportant channels.

4.2 Data

The data used in this study consist of a balanced panel of 148 macroeconomicvariables with a monthly frequency from January 2006 to March 2015. The datarepresents several economic concepts, namely, economic activity, inflation, interestrate, credit, exchange rate, asset price, inflation expectation and global financialfactor. Economic activity and inflation factors are target variables while theinterest rate, credit, exchange rate, asset price, inflation expectation areintermediate targets representing the transmission channels of monetary policyonto the economy. The BI rate is the policy rate representing the central bankmonetary stance.

The economic activity dataset contains variables of industrial productionindex, real GDP (interpolated monthly), capacity utilization, retail sales index andconsumption and sales data. The economic series used to explain inflation consistsof consumer price index and wholesale price index with their components.Interest rate factor is estimated from credit rate, deposit rate, overnight interbankrate, and Jakarta Interbank Offer Rate data with different time horizon. For thecredit factor, the volume of investment, consumption, and working capital creditsare used. The exchange rate factor is constructed from bilateral exchange ratesof the Indonesian rupiah to major currencies. For the asset factors, data on thestock price index, price earning ratio, and government bond yields for differentmaturities are used. The inflation expectation factor comprises datasets ofproducer and consumer price expectations. Lastly, for the global economiccondition, the dataset includes the S&P index, VIX index, USD Basket Index,commodity price index and various financial variables from advanced economysuch as monetary policy rate, total assets of central banks, government bondyield, and corporate bond yield.

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Unit root tests were applied, and the data is transformed to ensurestationarity. Usually, interest rates variables are stationary and, therefore, arenot transformed while other variables are transformed into the first differencedin the log to ensure stationarity. The lag length selection is based on severalcriteria: sequential modified LR test statistic (LR, LR, Final prediction error(FPE), Akaike Information Criterion (AIC), Schwarz Bayesian InformationCriterion (SBIC), and Hannan-Quinn information criterion (HQ). For the LR, alag length of 4 was selected, FPE 2 lags, AIC 8 lags while the other two criteria(SC and HQ) indicate one lag. For two lags, the result of the serial correlationLM test shows that there is no serial correlation at 5% level, and there is nohint of heteroskedasticity at 2-lag model. We use the lag chosen by FPE.

The restrictions are short-term and contemporaneous on the structuralparameters of A0 and no restrictions on lagged parameters. The contemporaneousrestrictions enable us to derive reasonable economic structure.

The first and second equations are real activity and inflation equations. Wefollow Brischetto and Voss (1999) and Tahir (2012) and assume they will onlyadjust slowly to the financial variables in the model. One reason is that we usemonthly data, and therefore, it is intuitive to assume that the GDP or inflationare not instantaneously responding to the other variables. The third equation isthe policy reaction function of the central bank. We assume the policy rate todepend contemporaneously on the inflation and activity following Tahir (2012).As Indonesia is an inflation targeting country, it is reasonable to assume that the

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central bank is forward looking and forecast the gaps of the output and inflationand thus responds contemporaneously to the current month inflation and industrialproduction index.

The fourth equation is the interest rate that is assumed to respondcontemporaneously to the policy rate. The fifth equation is the response of credit.We follow Berkelmans (2005) and Tahir (2012) and assume that the creditresponds contemporaneously to interest rate and output. The contemporaneousinteraction of credit with the interest rate is justified by the perception thatborrowers and potential borrowers will respond quickly to the cost of credit.Furthermore, we assume that there is a certain percentage of loans on flexibleinterest rate, thus causing credit to respond quickly to interest rate. As for responseof credit to the output, as argued by Berkelmans (2005), the expectation offuture activity is an important determinant of credit demand. Current activity, asobserved by individual agents, and interest rates should give some indication ofwhat future conditions hold.

In the sixth equation, we assume that the exchange rate dependscontemporaneously on the policy rate and interest rate. As the exchange rateis a financial variable, we assume it reacts quickly to all information. Theresponse of asset price is quite similar to the exchange rate’s, which is assumedto respond contemporaneously to the interest rate and exchange rate. The lastequation is the inflation expectation that responds contemporaneously to the policyrate and exchange rate. As inflation targeting framework has been implementedin Indonesia since 2005, it is realistic to assume that both the producer andconsumer form their expectations, relatively quickly, based on the policy rate.

Table 1 shows the estimated contemporaneous coefficients in the structuralmodel. The identifying restrictions are not rejected at 5% significance level asshown by the likelihood test of over-identifying restrictions at the bottom of thetable.

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5. Empirical Results

The estimated impulse response of the factors is shown in Figure 10. Eachfigure shows the impulse response for each macroeconomic factor to a one-standard deviation positive shock to monetary policy. The confidence intervalband in each graph is one-standard-error.

Table 1Contemporaneous Coefficients

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The responses are generally of the expected sign and magnitude andstatistically significant. Following the increase of the BI rate, interest rates increaseimmediately. The increase of the BI rate is then followed by the decrease ofcredits (TOTCR) as predicted by the financial accelerator and bank lendingchannel theoretical model. The rise in uncertainty about the credit quality offirms and households makes financial institutions more cautious about lendingloans which then translate into higher interest rates and tighter standards forlending. The increase in the BI rate also decreases financial institutions’ liquidityand capital buffers, thus reducing their ability to lend. The ultimate impact is thedecline in new loans.

The exchange rate (NER) appreciates as the domestic interest rate increases.When asset prices go down, inflation expectation also decline. The real activitymeasures decline, as expected, eight months after the initial shock. Inflationeventually declines after approximately 16 months. There is no “price puzzle”

Figure 10Cumulative Impulse-response Functions of Factors Due to Shocks of

the BI Rate

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found, where monetary policy tightening is followed by a rise in inflation, anoutcome at odds with conventional monetary policy theory.

With the FAVAR approach, the response of every variable in the model canalso be extracted. The estimated impulse response of a selection of keymacroeconomic variables to a monetary policy shock is shown in Figure 11.

Similar to the response of the factors, the responses of the variables areas expected. The first two graphs are the investment credit interest rate and 12-month deposit rate that immediately increase after a contractionary monetarypolicy. The BI rate increase is then translated into the decline in credit representedby the investment credit volume (TOTCRINV). The exchange rate factor isrepresented by the nominal exchange rate of Indonesian Rupiah to US Dollar(NERIDRUSD), which appreciates following a tightening of the monetary stance.Asset prices decrease as shown by the declining stock index (IHSGINDXX)and the increasing yield of government bond (IDGBND7Y). Real activity declinesas represented by the real GDP and Industrial Production Index (IPINDEXS).Inflation expectation goes down as shown by the producer price expectation(PPRICEXP6M). Inflation eventually declines as represented by the consumerprice index (IHKINDXX), core CPI (IHK CORE), and wholesale price(IHPBMPRT).

Figure 11Cumulative Impulse-response Functions of Variables Due to Shocks

of the BI Rate

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To measure the relative importance of the monetary transmission channels,we use the Variance Decomposition Approach following Tahir (2012). Variancedecomposition can provide complementary information for the betterunderstanding of the dynamic relationship between variables jointly analyzed ina VAR model. This tool is an approach to determine the fraction of the forecastingerror of a variable, at a given horizon, attributable to a particular shock. Thus,it allows a comparison of the role of different variables in explaining the variationin a certain variable, namely, the relative importance. The target variables areReal Activity and Inflation. To assess the relative importance of each monetarytransmission channel represented by the factors, we use the share of variationof the channel variable in explaining the fluctuation in the target variables.

The variance decomposition of inflation and real activity caused by theshocks, with each of the shocks representing a transmission channel, is presentedin Table 2 and Table 3. The numerical figure indicates the percentage fluctuationin the inflation and real activity caused respectively, by the intermediate variablesrepresenting the transmission channel. The higher the number, the higher therelative importance of that variable.

Table 3Variance Decomposition of Real Activity

Table 2Variance Decomposition of Inflation

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For inflation, the interest rate channel appears to be the most dominantchannel followed by the credit channel. This finding seems plausible, given theinflation targeting framework in Indonesia and the dominance of the bankingsector in the financial system. It is based on the assumption that the bankingsector translates the policy interest rate into bank lending rate and creditefficiently, thus making the interest rate and credit, the most important channels.The asset price, inflation expectation, and exchange rate also transmit monetarypolicy although they are less dominant than the interest rate and credit channel.For real activity, the credit channel appears to be the most dominant, followedby the asset price channel. The results appear to be relatively consistent usingdifferent forecast horizons.

6. Conclusion and Policy Implications

Monetary policy, in this case, represented by the policy rate, BI rate, appearsto empirically affect real activity and inflation through every channel (interestrate, credit, exchange rate, asset price and inflation expectations). However,there is a lag of approximately 16 months in the transmission of monetary policyon inflation. The most important channel for transmitting monetary policy toinflation is the interest rate and credit channel. This finding is consistent withthe inflation targeting framework and the importance of the banking sector inthe financial system. This research contributes to the existingresearch on monetarypolicy transmission of Bank Indonesia in that it takes into account all the channelssimultaneously, by using the Structural FAVAR and ranking the transmissionchannels according to their impact on variation in the GDP and inflation.

From this research, we can glean that there is room for improving theeffectiveness of the inflation expectation channel. As the impact of inflationtargeting on inflation and other macroeconomic variables may rise through itseffects on inflation expectations and on the expectations formation process, theinflation expectation channel is expected to play a more important role in thetransmission of monetary policy. One strategy is to improve communicationbetween the monetary authority and economic agents that could lead to lessdispersion of expectations. The fall in the dispersion may enhance theeffectiveness of the expectations channel of monetary transmission which, inturn, can reduce the level of inflation (Martinez, 2011). Another strategy is toprove to the public that the central bank has been succeeding in achieving theinflation target for several occasions. This is very challenging for Bank Indonesiasince the inflation target set by the government is quite low while manyadministered price components are adjusted, for example, fuel, gas, and electricity.

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Appendices

Data Sets

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