The role of financial and exchange rate policies in Indonesia's macroeconomic adjustment

Abstract

This dissertation deals with Indonesian exchange rate policy, focusing the period from 1978 until 1987 during which Indonesia had a government-managed floating system. Economic policies in the monetary, fiscal, commercial and international payments areas are also discussed as they played important role in determining the efficacy of the exchange rate policy.

An empirical model for the central bank exchange rate policy reaction function is developed. Estimation results suggest that the authorities reacted more to the change in the home-foreign interest differential and less to the change in foreign reserves in managing daily movement of the nominal exchange rate. The home-foreign inflation differential was used as a measure of the need for a major devaluation.

Other empirical works have examined the impact of the exchange rate policy on the real exchange rate and hence the balance of trade. Our findings confirm that attempts to stabilize nominal exchange rate led to a continuous appreciation of the real exchange rate and hence a decline in incentive for tradable goods producers relative to that for nontradable goods producers. The effect of a real devaluation, defined as an increase in the relative price of tradable goods, on the trade balance was positive even in the short run, but generally took at least six months for a devaluation to have a full real effect.