Money velocity, digital currency, and inflation dynamics in Indonesia*

Abstract

This paper empirically investigates the impact of transaction cost-induced variations in the velocity of money on inflation dynamics in Indonesia, based on a structural New Keynesian Phillips curve (NKPC) with an explicit money velocity term. The money velocity effect arises from the role of money, both in physical and digital forms, in reducing the aggregate transaction costs and facilitating purchases of goods and services. We find a non-trivial aggregate impact in the context of the Indonesian economy: our benchmark estimates suggest that a 10% decrease in money velocity, which might be facilitated by a new digital currency (e.g. CBDC) issuance, would reduce the inflation rate by 0.6-1.7%, all else equal. Using the estimates and within a small-scale New Keynesian DSGE model calibrated to the Indonesian economy, we show that shocks to the velocity of money are an important driver of aggregate fluctuations. The model’s simulation shows that a CBDC issuance roughly equivalent in value to 5% of nominal GDP in Indonesia in 2023 would permanently increase real GDP by 1% and lower the inflation rate by 1%. Both nominal and real interest rates are also permanently lower. Our findings imply that central banks could potentially use CBDCs as an additional stabilization policy tool by influencing the velocity.