Modelling the Demand for Indonesia’s Foreign Reserves

Abstract

Abstract The foreign reserves sufficiency is important to maintain macroeconomic stability. The main objective of this paper is to model the behaviour of the central bank in accumulating the foreign reserves in the case of Indonesia. Unlike the previous empirical studies, this paper disaggregates the components of foreign reserves into foreign currency, securities, gold, and special drawing rights. This paper relies on the Almost Ideal Demand System combined with the Error Correction Model. The estimation result for monthly data over the period 2010(1)-2020(12) reveals that the own-price coefficients are negative and statistically significant which is consistent with the standard theory of demand. While the foreign currency-securities pairwise is substitutive, the foreign currency-gold and the foreign currency-special drawing rights pairwise are complementary or even independent. However, the wealth effect is inelastic except for securities reserves. These results imply that the central bank of Indonesia can re-balance its reserves. The securities holding which have the highest proportion of foreign reserve scan be switched to foreign currency, gold, and/or special drawing rights. The rebalancing measures would remain having an optimal level of foreign reserves holding in terms of its opportunity cost. Therefore, the monetary authority can conduct a further macroeconomic stabilisation without substantially losing the returns.