The Influence of Exchange Rate and Foreign Capital on the Performance of Inflation Targeting Framework in Indonesia

Abstract

This study provides empirical evidence on the problem of the trilemma of monetary policy in an open economy, in the context of the effect of exchange rates and foreign capital flows on the performance of the ITF in Indonesia. The method used as an empirical estimate is the Structural Vector Autoregressive (SVAR) model. This model allows to include restrictions in the empirical estimation of parameters that measure the contemporaneous effect of one variable on another variable according to the structure of the macroeconomic model. Meanwhile, the lagged effects are estimated according to the VAR model. Therefore, the SVAR model is considered more appropriate than the ordinary VAR model because it can measure both the instantaneous effect and the intertemporal effect of the problem under study. The SVAR model uses restrictions that are consistent with the theoretical model in its estimation, regardless of the time-to-time effect of one variable on another. There are 9 variables in the SVAR model, namely: global risk, oil prices, federal funds rate, economic growth, inflation, interest rates, monetary policy, credit interest rates, foreign portfolio investment flows, and the rupiah exchange rate. All data used were obtained from several sources, including: Bank Indonesia, Central Statistics Agency, and IMF. Based on the estimation results, the exchange rate and foreign capital flows have a significant effect on inflation and economic growth, thus affecting the performance of the ITF in Indonesia. In particular, there is a relative influence between external factors, particularly global commodity prices, US monetary policy interest rates, and global risks, and domestic factors, particularly economic growth, monetary policy interest rates, and bank interest or credit rates. This study also concludes that in addition to inflation and economic growth considerations, Bank Indonesia also considers exchange rate movements in determining its interest rate policy response.