The Time-Variant Sources of Inflation and Inflation Volatility and Their Interrelations and Effects on Macroeconomic Fluctuations: Evidence from Indonesia and Thailand

Abstract

Indonesia and Thailand, two major open economies in Southeast Asia which operate under ‘managed-float’ exchange rate systems, have remained susceptible to both the external and domestic shocks since the East-Asian financial crisis of the late 1990s. Unlike the standard monetary-policy literature, these countries have introduced ‘flexible inflation targeting’ as the monetary policy strategy under managed- float exchange rate systems. Although these countries have managed to keep inflation low on average in a low-inflation environment, inflation has however remained highly volatile. This paper attempts to answer how significant are external shocks, relative to domestic shocks, as the drivers of inflation and inflation volatility for these countries? The paper uses a Structural Vector Autoregression (SVAR) modelling framework and monthly macroeconomic data over the period 2000M1-2015M12. The empirical results suggest that in both countries, (i) inflation is more sensitive to external shocks relative to domestic shocks, which is consistent with the inflation globalization hypothesis; (ii) Inflation volatility however remains sensitive to both the external and domestic shocks; (iii) As expected, inflation and inflation volatility exhibit a feedback relation between them, which is consistent with the Friedman-Ball and Cukierman-Meltzer propositions. The paper also highlights that inflation and inflation volatility affect the real interest and exchange rates, which affect real output and asset prices. The paper concludes that Indonesia and Thailand can make monetary policy more effective for maintaining price stability if they make the exchange rates more flexible to ameliorate the effects of external shocks on these economies.