Inflation Expectations and Monetary Policy Rules: Findings from Indonesian Economy

Abstract

The main objective of this study is to understand how Bank Indonesia conducts its monetary policy as part of the implementation of inflation targeting. The paper adopts a modified Taylor rule for monetary policy decision-making, using public inflation expectations data to complement the traditional use of output gaps. Based on the empirical estimation with Indonesian data, it was found that a modified Taylor rule model using public inflation expectations can replicate reasonably well the current Bank Indonesia policy interest rates. It is also found that a Taylor rule using more frequent (monthly) data can capture and adjust to unexpected shocks more quickly and complement the use of quarterly data as in the original model. The paper finds that, Bank Indonesia has targeted core inflation as its monetary policy objective, and provides evidence that the use of core inflation can improve the bank’s credibility. The findings imply that Bank Indonesia should consider a rule-based policy approach using public inflation expectations and core inflation, if it plans to adopt a monetary policy rule in the future.