Monetary policy effectiveness under financial deregulation : the case of Indonesia, 1983-92

As a consequence of financial Indonesia which has been undertaken deregulation in since 1983 for improvement of Indonesia's macroeconomic performance through a greater reliance on market forces, the conduct of monetary policy has been redirected from the use of interest rate and direct credit controls to the use of indirect instruments of open-market operations. This study investigates econometrically the effectiveness of Indonesia's monetary policy as a consequence of the financial deregulation during 1983-92. The empirical investigation of this study explores the role of monetary aggregate (Ml) in predicting prices (inflation rate), the stability of money demand and the structural interactions between financial and real variables during the pre- and post- deregulation periods. The empirical investigation also explores the impact of Indonesia's financial deregulation in promoting savings and efficient investment including their correlation with interest rates and exchange rate. The empirical investigation required the use of several methods: the variable Granger causality test was used to investigate causality between prices and Ml; the Engle-Granger two step procedure of cointegration techniques was used to explore/test money demand stability; the VAR approach was used to assess structural interactions among financial and real variables; and the multi variable regression method was used to analyse savings and investment. The overall results suggest that financial deregulation improved (with qualification) Indonesia's monetary policy effectiveness during 1983-92. The results have practical and theoretical implications for Indonesia's decision making and further studies of monetary policy. First, Ml can be used as a guide for predicting prices or inflation rate (in previous studies no causal relationship was shown).