Is money targeting an option for Bank Indonesia?

Abstract

In this paper, using the cash-in-advance model, we estimate Indonesia's money demand function for the period 1970–2005. We find the real M1 and real M2 are cointegrated with their determinants, namely real income, real exchange rate and short-term domestic and foreign interest rates. The long-run elasticities, except for the relationship between M2 and domestic interest rate, are plausible. Interestingly, we find a negative relationship between real exchange rate and real money demand, suggesting evidence of currency substitution. We test for causal relationships and find that in the short-run only the real exchange rate Granger causes real M1 and real M2. Finally, we find that Indonesia's money demand functions are unstable. We conclude that money targeting is not an option for Bank Indonesian and that currency substitution should be curbed in order to ensure macroeconomic sustainability.