Monetary Policy and Economic School of Thought

Thursday, April 9, 2009

Monetary Policy and Economic School of Thought. The influence of monetary policy on output and prices is a long debate concerning both theoretical and empirical terms. This is not detached from the economic development school of thought from start Classical, Neo-classical, Neo-classical synthesis, New Classical and New Keynesian.
In Classical view, money affect only the price and not to the output. By using analysis general equilibrium, included money in the model showed the money neutrality that money does not affect on market equilibrium. On the other hand, the Keynesian view of money affects prices and output because of the price rigidity and involuntary unemployment. This view is modeled on the IS-LM for the equilibrium of money market and goods market and disequilibrium on the labor market.
In the 1960s there consensus view that the money may affect output and prices in the short term (Neoclassical Synthesis). In that period, structure of the labor market is replaced with Phillips curve as aggregate supply. Neoclassical Synthesis model explained that the occurrence of rigidity prices and wages because of the assumptions in determining the behavior of company that is the price mark-up of wages. Although the real wage is flexible, but the pricing behavior conducted in the mark-up so lead to occurring rigidity wages and prices and then money supply affect real output and prices.
Expectation economic agent face economic uncertainty will influence macroeconomic. Two important hypothetical of expectation in the economy are rational expectation and adaptive expectation. Milton Freidman (1957) introduced the adaptive expectation that the expectation economic agents formed by observations of inflation at this time. Phenomenon of the Phillip curve was challenged by Friedman points out that the argument only unanticipated inflation are affecting unemployment. He emphasize on the importance of expectation on the aggregate supply so that revised Phillips curve as expectation-augmented Phillips curve.
On 70’s, it is difficult period for the Keynesian. Lucas (1976) and Sargent-Wallace (1975) introduced the rational expectation that assume economic agents use all relevant information to establish expectation or forecast economic variables in the future. So that monetary policy and fiscal policy affects inflation, than expectation inflation also depend on effect those policies. Thus, changes in monetary and fiscal policies affect the changes expectation agent economy. So, the policy evaluation must consider the effects of expectation economic agents.
Lucas (1976) criticize the results of parameter estimation econometric model that is not stable because occurring the changes policy maker behavior, and than expectation of the private agent will also be changed then it will affect the parameters in the econometric model. This critique affect on two, the revised macroeconomic model with rational expectation of entering and strengthening macroeconomic model with micro foundation.
At the 80’s Classical school of thought was extremely dominant. In the New Classical paradigms, Kydland - Prescott (1982) introduced the real business cycle theory (RBC), which begins with microeconomic assumption of household consumption preference, the production firm and market structures. With the intertemporal optimization of consumption of households and future profit of firms and the market is competitive then the solution obtained by dynamic general equilibrium model. They succeeded in making data replication USA. RBC model assume output is always in the natural level of output and all of output fluctuations are the movement of natural level of output itself. The cause of output fluctuations in Prescott point of view is a shock or a change in technology. Similarly, in the RBC model change in money supply does not affect output.
After the 80’s, research on RBC develop in many models. Debate on technology shock provides inspiration for researchers to develop various models incorporate various aspects, among others; oil shock, fiscal shock, monetary model, and the multiple equilibrium model (Rebelo, 2005).
The latest research on the RBC model related to monetary policy is to include elements of nominal wage and price rigidity in the model, so that changes in money supply can affect output. This model, known as Dynamic Stochastic General Equilibrium (DSGE) model. Some researchers Christiano, Eichenbaum and Evans (2003), Woodford (2003), Smets and Wouters (2004); and Laxton and Pesenti (2003) build and estimate DSGE model based RBC with assumptions nominal rigidities in wage and price, including assumption imperfect competition in market labor market and product market.
Another mainstream New Keynesian is the improvement of the Neo-Classical synthesis with incorporate aspects of the rational expectation and strengthening the micro foundations. However, the Keynesian economists still believe the existence of imperfect markets and nominal rigidity can lead to fluctuations (deviation) of output from natural output. Fischer (1977) and Taylor (1980) argued that the occurrence of the nominal rigidity caused staggering of wage and price decisions by firms. The existence of staggering in wage and price lead to adjustments on price level slowly so that changes in aggregate demand impact on output fluctuations.
In New Keynesian paradigms, the economists [Gali and Gertler (1999) and Gali et al. (2001), Roberts (2001), Fuhrer (1997); Linde (2005)] has to learn how to develop a simple model, related, and structural that could explain mechanisms transmission of monetary, especially through the interest rate and the impact on inflation and output. This model is known as model New Keynesian Small Macroeconomics (NKSM) with approach dynamic stochastic general equilibrium that contain aspects expectation and also solid with micro foundation. This simple model is also containing the aggregate demand, price-setting (Phillips) curve, and the reaction of an interest rate policy to output and inflation. This model to realize the basic principle of the role of monetary policy instruments through the nominal interest rate to inflation stabilization.
Technically DSGE models have weaknesses in terms of technique calibration that difficult to create the replication of data in accordance with the actual data, but the advantage that the DSGE model parameter is the "deep parameters" (parameters for the micro variables). While NKSM have benefits to explain economic conditions simpler, but the weakness is difficult to get the relationship between variables significantly because of the unobserved variables or serial correlation.

Paper in Indonesia Language.
Keyword: Classical, DSGE, Economic, IS-LM, Neo-classical, Neo-classical synthesis, New Classical and New Keynesian, Phillips curve, Price rigidity, Rational Expectation, RBC, wage rigidity.

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The Economist on Indonesia

Monday, January 19, 2009

The Economist are quite optimistic on Indonesia:
The data suggest the fourth-quarter slowdown in Indonesia was much less pronounced than elsewhere in South-East Asia. Economic growth for 2008 as a whole is likely to exceed 6%. The 2008 budget deficit was 0.1% of GDP and the government has earmarked $3.5 billion to spend on tax breaks and infrastructure projects. In late 2008 the currency, the rupiah, lost a fifth of its value against the dollar, but the slide has halted. The cost of insuring Indonesian government bonds against default has come down sharply. Inflation, still running at an annual rate of 11%, is falling. The central bank cut interest rate by one-half of a percentage point, to 8.75%. Most banks are healthy. Moody’s, a credit-rating agency, gave Indonesia a “stable” outlook in its annual report this week, expecting the authorities to manage the impact of the crisis competently.

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Currency Crisis Effect on the Stock Market: A Case Study in Indonesia

Monday, December 1, 2008

Currency Crisis Effect on the Stock Market: A Case Study in Indonesia. This essay has analyzed the Indonesian currency crisis by empirically examining relationships between the composite share price index and sectoral stock indices of the Jakarta Stock Exchange and the exchange rate. The results show that changes in composite price index and property and real estate, financial indices provided early indication of the currency crisis when the central bank applied a managed float regime. The VAR test shows that these stock indices (in differences) caused exchange rate changes before the crisis period.

There has been a strong causality relationship from the rupiah exchange rate to the composite share price index and all the stock indices during the post crisis period. All stock market indices can be explained by the exchange rate changes. The tradable goods producers such as mining and manufacturing have positive sensitive to exchange rate changes. They become better off when the exchange rate depreciates. On the other hand, non-tradable goods producers such as property and real estate and infrastructure will become worse off when the exchange rate depreciates.

The causality relationship between the exchange rate and the stock market indices disappeared during the peak crisis period. Many factors influenced the exchange rate, such as a social and political instability and a loss of confidence by investors.

This study has implications for monitoring financial markets. Currently, the monitoring practice for the financial sector is based on a portfolio approach, often relying on low frequency data, due to the reporting practices of financial entities. However, high frequency financial indices such as stock indices can supplement some deficiencies of the conventional method, as the stock indices such as the composite share price index, financial, property and real estate indices showing early indicator currency crisis, especially in the pre-crisis period.
Finally, for further research we can relax the assumption of a constant interest rate and develop the model considering the time-varying interest rate. This is because we should consider the variation of domestic interest rates in order to improve the goodness of fit of the model.

Complete paper in English


Summary paper in Indonesia language.

Keyword: Composite Index, Currency Crisis, Exchange rate, Financial, Jakarta Stock Index, Rupiah, Stock Market

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PANEL UNIT ROOT TEST

Sunday, November 16, 2008

In the last decade, the issue of unit root test for heterogenous panels has attracted many academic researchers. In principle the application of the panel data unit root test is intend to increase the power of test by increasing number of sample. Increasing amount of sample can be done by increasing the number of cross sectional data and the number of time series data. The problem emerge in panel data are the issue of structural change when using long data series or contain heterogeneity when using cross sectional data. The famous example unit root test for homogenous panel was Summer and Heston (1991) using a panel data set covering a variety of industry, region, various country with a long period of time.
Unit root test has been developed by Quah (1992.1994), Levin and Lin (1993) for homogenous panels. That testing the unit root can not accommodate heterogeneity between groups, such as the unique influence of individuals (individual special effects) and a different pattern of residual serial correlations. Test statistics that proposed by Quah, Levin and Lin can more be used with the conditions for the existence of specific individual effects and also heterogeneity across groups and then requires N / T -> 0 and two N (cross section dimension) and T (time series dimension) toward unlimited.

Pesaran and Smith (1995), and Pesaran, Smith and Im (1996) showed that the inconsistencies in the estimation model dynamic heterogeneous panels. Furthermore, based on the paper, the Im, Pesaran and Shin (2002) introduced the unit root test with dynamic heterogeneous panels. In general, the unit root test with dynamic heterogeneous more used compared with the homogenous dynamic. Im, Pesaran and Shin (IPS) framework using the likelihood procedure based on an alternative test average unit root test statistics in each individual group for the panel. IPS was testing based on the average (augmented) Dickey Fuller (1979), which refers to the t - test bar. Such as procedures performed by Levin and Lin, unit root test done by the IPS is to consider the characteristics of serial correlation dynamics and heterogeneity residues for each panel group. Statistics (IPS) is indicated in the convergence of the standard normal probabilities in line with sequential T to unlimited number, and followed by the N to unlimited number, where T is the time series dimension and N is the cross sectional dimension. The diagonal convergence between T and N to unlimited number, while NT -> k, where k is a constant non-negative limited number. In special cases, where the residual of the individual DF Regression are serially correlated, then Z ~ tbar which is a modified t-stat will distributed with the normal standard at the time of N → ∞ and T fixed, so that the length of T> 5 for the regression with the intercept and DF T> 6 for DF regression with intercept and linear time trends. Next, the test was also developed to test how T and N fixed with the average DF. Simulation results that with the big ordo of the ADF regression; the performance of the limited sample t-bar test is very satisfactory and gives better results than Levin-Lin (LL) test. Therefore, in this paper will attempt to simulate formulas and procedures of Pesaran.

Complete Paper in Indonesia Language.
Summary Paper in Indonesia Language.

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