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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