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Indonesia 2000-2006:
Walking the Fiscal and Monetary Policy Tightrope
Jonathan Haney, David Kase, Vishaal Rana
Public Policy 542
PUBPOL 542: Indonesia Presentation
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
PUBPOL 542: Indonesia Presentation
Macroeconomic Overview: Key Indicators
2002
2003
2004
2005
2006
2007
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
109,145
(5,397)
21,832
112,164
Positive
Slightly
Positive
-
-
-
-
9.75%
8.0-8.5%
Current
Account
Interest Rate
PUBPOL 542: Indonesia Presentation
Macroeconomic Overview: Selected Comparable Indicators
2002
2003
2004
2005
2006
Indonesia
4.4%
4.7%
5.1%
5.6%
6.2%
ASEAN
4.8%
5.4%
6.1%
5.6%
5.8%
Indonesia
10.0%
6.8%
6.1%
10.5%
13.2%
ASEAN
7.3%
5.1%
4.8%
7.4%
8.1%
Indonesia
13.6%
7.1%
6.7%
11.8%
9.7%
ASEAN
5.7%
5.3%
5.0%
5.7%
4.2%
Real GDP Growth
Inflation Rate
Interest Rate
Source: ASEAN
Note: Interest Rate is 3 month time deposit
PUBPOL 542: Indonesia Presentation
Macroeconomic Overview: Government Spending and Tax Collection
Revenues vs Expenditures
 Government is moving
towards a balanced budget
 High military spending
compared to social services
Taxes as Percentage of Government Revenue
 Tax recovery rate has
accelerated since
financial crisis, but still
below historical
PUBPOL 542: Indonesia Presentation
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
PUBPOL 542: Indonesia Presentation
S (IDR/USD)
Zones of Discomfort
 Economic Production
CA is slightly
negative
(~500MM USD)
 Unemployment is currently
at 12.6%
 Underemployment is
expected to be
significantly higher
Indonesia
●
 17% are living below the
• Excessive CA
surplus
• Underemployment
poverty line
 Current Account
 Given their developing
economy, CA should be
negative
 However, Indonesia has a
Economy is at full
employment
Fiscal Ease (G↑ or T↓)
PUBPOL 542: Indonesia Presentation
surplus and needs to plow
that surplus back into
economic growth
Aggregate Demand (D)
Output Market Equilibrium (DD schedule)
 Many avenues exist to
D=Y
(t=11%)
(t=12%)
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
Y0
Y1
Output (Y)
PUBPOL 542: Indonesia Presentation
Exchange Rate (S)
Current Asset Market Equilibrium (AA schedule)
 Currently the real money
S1
supply is growing
 Between 2000 & 2005,
S2
S0
Interest rate parity
curve shifts
outward due to
expected inflation
the money supply has
grown by 74% and
inflation has grown by
55%
 This causes the exchange
Real Domestic Money
Holdings (MS/P)
Dom Interest
Rate (i)
rate to “overshoot,”
creating a much larger
depreciation of Rupiah
 The resulting reduction in
M s 73.9%

P
54.9%
PUBPOL 542: Indonesia Presentation
exchange rate hasn’t
occurred because the
economy hasn’t returned
to steady state or seen
real money supply
contraction
Exchange Rate (S)
Proposed Asset Market Equilibrium (AA schedule)
S0
 Our recommended steps
S1
S2
S2
S1
work to pull down the real
money supply.
Interest rate parity
curve shifts inward
due to expected
appreciation
 As currency dries up,
inflation will be put under
pressure to reduce as the
money supply contracts
 Again, the currency will
Real Domestic Money
Holdings (MS/P)
Dom Interest
Rate (i)
M s 4 %

P
6%
PUBPOL 542: Indonesia Presentation
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)
Exchange Rate (S)
Recommended Action Steps AA-DD Curve

DD0
DD1
Our action plan is a
series of steps
1.
DD3
S0
2.
AA2 AA0
3.
Y0Y2 Y1 Y3
Yf Output (Y)
PUBPOL 542: Indonesia Presentation
Grow the economy
through fiscal policy
action (e.g., tax rate
decrease)

Currency appreciates

Output increases
Tighten monetary supply
through a real money
supply contraction

Output decreases

Currency appreciates
Repeat the process

Strategy will have to
change once country
reaches full
employment
Questions?
PUBPOL 542: Indonesia Presentation