Drivers of Inflation and Inflation Volatility and Their Effects on Macroeconomic Fluctuations in Indonesia and Thailand

Abstract

Indonesia and Thailand, two major open economies in Southeast Asia operating under managed-float exchange rate systems, have remained susceptible to both external and domestic shocks since the East-Asian financial crisis of the late 1990s. This paper investigates the transmission of external shocks to these economies via their impact on inflation and inflation volatility. The empirical results suggest that in both Indonesia and Thailand, inflation and inflation volatility are more sensitive to external shocks relative to domestic shocks, consistent with the globalization hypothesis. Inflation and inflation volatility are also found to have a feedback relation between them, consistent with the Friedman‐Ball and Cukierman‐Meltzer propositions, and they drive the real exchange rate up while adversely affecting output and asset prices. A positive inflation shock has immediate and persistent adverse effects on domestic output, consistent with the inflation literature for developing countries. The empirical results highlight the implications for economic theory and policy measures. In Indonesia and Thailand, policymakers can improve the conduct of rule-based monetary policy by fostering a more flexible exchange rate regime, to keep inflation stable and to raise the people’s social welfare.