Inflation dynamics and monetary policy in Indonesia

Since the last two decades, many countries around the world have gone through a significant transformation in monetary policy. Their central banks now set low and stable inflation as their ultimate target in the long run. The main components of the successful implementation of this inflation targeting are transparency and credibility, and their accomplishment will be judged by public in their expectations about future inflation. As a result, the central banks implement a set of modern monetary policy principles to improve their transparency and credibility, and one of those modern principles is the adoption of a monetary policy rule. In this study, we attempt to investigate the conduct of monetary policy under an inflation targeting framework and explore the role of public inflation expectations in the monetary policy rule. We develop an expectations-augmented Taylor rule model for monetary policy using public inflation expectations and core inflation data to replace the traditional output gap and actual inflation, respectively.