Unveiling the Asymmetric Adjustments of Policy Reaction Function in Indonesia

Abstract

The standard Taylor rule assumes that monetary policy can be represented by a linear reaction function. This study extended previous research to investigate if there is any asymmetric adjustment in the policy reaction function of Indonesia as this country experienced a drastic shift in the monetary policy regime and exchange rate system from the impact of Asian financial crisis. To be more specific, we tend to reveal the behaviour of policy function towards variation in inflation and output gap over time changes. In the same way, we also seek to capture if there is any influence of exchange rate changes on policy function in two contrasting eras. Therefore, a nonlinear regression model (threshold approach) is applied to estimate the policy reaction function of Indonesia in two different sub-periods; pre- (1980Q1–1996Q4) and post- (2000Q1–2015Q4) inflation targeting (IT) regime. Our analysis with two threshold factors: exchange rate (LREER) for pre-IT and inflation (LCPI) for post IT, addressed asymmetric adjustments of policy rate towards inflation variation and output gap in both sub-periods. In the pre-IT, the policy rate is only responding to output gap. Turning to post-IT, the policy rate is reacting more actively to inflation variation than output gap but never to changes in the exchange rate. This validating a pure floating regime accompanied by inflation targeting policy framework aftermath crisis in Indonesia.