Observed Inflation‐target Adjustments in an Estimated DSGE Model for Indonesia: Do They Matter for Aggregate Fluctuations?

Abstract

This paper investigates the role of observed official inflation‐target adjustments in aggregate macroeconomic fluctuations in Indonesia, using an estimated Dynamic Stochastic General Equilibrium model. The paper finds that these adjustments or shocks play a non‐trivial role in the fluctuations of inflation and nominal interest rate in Indonesia. Output fluctuations, however, are virtually unaffected. A counterfactual exercise shows that a faster disinflation policy, through an immediate decrease in Bank Indonesia's inflation target, may have resulted in a lower average inflation and nominal interest rate, with virtually no output loss. The paper also provides additional insights on the contribution of various shocks in driving aggregate fluctuations in Indonesia. Technology and monetary‐policy shocks are found to be the main driving factor for both output and inflation fluctuations. Movements in the nominal interest rate are mostly driven by preference and risk‐premium shocks, with inflation‐target shocks playing a larger role in the longer run.