Money, prices and finance in Indonesia : 1960-74

Abstract

This study examines the Indonesian price and monetary experience in the period 1960-74. The analysis of this past experience provides the opportunity to construct a policy guidance framework which might assist the Indonesian authorities in achieving price stability and in using the financial system to transfer resources between sectors. Starting from a description of the operation of the Indonesian economy, the analysis proceeds in stages of increasing rigour to the development of a model which provides a stylised picture of the operation of the financial sector in Indonesia. The model is built around the money market. It depicts the behavioural relationships which determine money demand and money supply and links these to the real economy - the market for goods and services - on the basis of simple assumptions. The model incorporates the policy instruments of the monetary authorities and their goals. Two main price-formation hypotheses are studied. First, the monetarist view that there is a close relationship between money and prices and that the authorities can control prices by controlling money supply. Secondly, the cost-push view, that there are certain critical prices in the economy which influence the general price level. The differences between these two views centre around the stability of the money demand function and the determinants of money supply, in particular whether money supply responds endogenously to price increases. Econometric estimation of the model is used to test the two hypotheses for Indonesia in the period under study. The same framework is then used to show how the operation of the financial sector influences the real sector. Transfers through the financial sector from money-holders to the government, by means of the 'inflation tax', are discussed in the standard literature. The model developed here can take this analysis further. By incorporating separate money demand functions for consumers (the household sector) and for investors (the business sector), the model not only shows how the ' inflation tax' shifts resources from money holders to the government , but how the same mechanism operating through the banking system can also bring about changes in investment. The model indicates how the financial sector might be enlarged to expand its role in bringing about resource shifts between sectors. The detailed econometric estimation results will be of some interest in themselves, but perhaps more important is the overall view which the analysis provides of the operation of the formal financial sector. The great variety of inflationary experience in the 1960-74 period can be seen as the result of one underlying behavioural system when it is recognised that the two policy goals - price stability and resource mobilisation - are to a large extent conflicting aims . Different policy-makers, with different sets of priorities, chose different points on the trade-off between these two broad aims. This study attempts to formulate the trade- off explicitly, so that it may assist the authorities in choosing and reaching their desired point on this trade- off.