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The IUP Journal of Monetary Economics
Inflation Expectations and Monetary Policy Rules: Findings from Indonesian Economy
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The main objective of this study is to understand how Bank Indonesia conducts its monetary policy as part of the implementation of inflation targeting. The paper adopts a modified Taylor rule for monetary policy decision-making, using public inflation expectations data to complement the traditional use of output gaps. Based on the empirical estimation with Indonesian data, it was found that a modified Taylor rule model using public inflation expectations can replicate reasonably well the current Bank Indonesia policy interest rates. It is also found that a Taylor rule using more frequent (monthly) data can capture and adjust to unexpected shocks more quickly and complement the use of quarterly data as in the original model. The paper finds that, Bank Indonesia has targeted core inflation as its monetary policy objective, and provides evidence that the use of core inflation can improve the bank's credibility. The findings imply that Bank Indonesia should consider a rule-based policy approach using public inflation expectations and core inflation, if it plans to adopt a monetary policy rule in the future.

 
 
 

It has been widely accepted in the literature that interest rates are the main instrument of inflation targeting by central banks. They set up the transmission mechanism of their monetary policy is such a way that the public are well-informed as to where the central bank is heading with regard to future inflation targets, and interest rates are the most readily observable variable in the market. Furthermore, central banks also use this monetary instrument to obtain feedback from the public. A well-accepted response by the public is a good indication for the bank that it should continue its current policy. On the other hand, when public sentiment changes, it may be an indication for the bank to find an alternative approach that reflects the change in public reaction.

A central bank that adopts inflation targeting is more concerned with measures to contain domestic inflationary pressures, rather than reacting to inflation deviation. This means that the central bank should pay more attention to the issue of isolating shocks that might affect the achievement of long-run inflation targets negatively. That is also why many central banks around the world do not react excessively to short-term fluctuations in the market, as they tend to focus on long-term outcomes (Bernanke and Mishkin, 1997). However, banks do use short-term interest rates as a way of influencing long-term price levels in order to achieve their predetermined targets. In the mean time, inflation expectations play a very important role in the monetary policy-making process. These provide the central bank with critical information regarding the public's expectation of future price movements. Accordingly, understanding the relationship between inflation expectations and interest rate policy is very important, especially as both the variables are directly related to the achievement of the ultimate objective of monetary policy, i.e., a low and stable inflation rate in the long run.

 
 
 

Monetary Economics Journal, Monetary Policy Rules, Public Inflation Expectations, Transmission Mechanism, Monetary Policy Making Process, Decision-Making Process, Domestic Financial Market, Monetary Instruments, Banking Mismanagement, Global Economic Developments, Domestic Banks.