Fiscal-monetary interaction in Indonesia

May 2008

Abstract

There has been a trend toward using monetary policy as the main stabilisation instrument, while fiscal policy has often been seen as either ineffective as a stabilisation instrument or unable to respond in a timely manner. There has, however, been renewed interest in fiscal policy as a stabilisation instrucment due to monetary union in teh Euro area, and due to low and stable inflation accompanied by substantial internal (UK) or external (New Zealand) imbalances. Moreover, in emerging economies, less complete markets potentially break Ricardian equivalence, creating a larger stabilisation role for fiscal policy.This paper explores the stabilisation role of fiscal policy in Indonesia. We use an estimated open economy DSGE model that features sticky prices and wages, nonRicardian agents and tax distoritions to explore the potential role for fiscal policy in stabilisation. The results suggest that fiscal policy can and does contribute meaningfully to macroeconomic stabilisation in Indonesia, leading to better outcomes than monetary policy alone. A large estimated share of nonRicardians (62 to 67%) is important in creating a role for fiscal policy. With a risk premium that is linear in debt, the fiscal debt plays an important shock absorber role, allowing active fiscal stabilisation and absorption of exchange rate valuation effects on the stocks of debt and reserves. Even in the absence of a direct effect on the exchange rate in the model, reserves accumulation is contractionary, leading to a small depreciation of the exchange rate.