How Does Monetary Policy Transmission Work?
The overriding objective of monetary policy is to safeguard and maintain stability in the value of the rupiah, reflected among others in low, stable inflation. To this end, Bank Indonesia sets a policy rate known as the BI 7DRR, which serves as the primary instrument for influencing economic activity with the overriding objective of achieving the desired level of inflation. However, the transmission of BI 7DRR decisions to achievement of the inflation target operates through highly complex channels and is subject to time lag.
The means by which BI 7DRR adjustments influence inflation is commonly referred to as the monetary policy transmission mechanism. This mechanism reflects the actions taken by Bank Indonesia through adjustments in monetary instruments and operational target with effect on a range of economic and financial variables before ultimately influencing inflation as the final objective. This mechanism operates through interaction between the central bank, the banking system and financial sector and the real sector. Changes in the BI 7DRR influence inflation through various channels, among others the interest rate channel, credit channel, exchange rate channel, asset price channel and expectations channel.
In the interest rate channel, changes in the BI 7DRR affect the levels of bank deposit rates and lending rates. If the economy is in a downturn, Bank Indonesia may launch an expansionary monetary policy by lowering interest rates to promote economic activity. Any reduction in the BI 7DRR will lower credit interest rates and in so doing fuel corporate and household demand for credit. Lower bank lending rates will also reduce the cost of capital for companies engaging in investment. All this will stimulate consumption and investment and in turn provide a boost to economic activity. Conversely, if there is mounting inflationary pressure, Bank Indonesia will respond by increasing the BI 7DRR to slow the excessive pace of economic activity and in so doing ease inflationary pressure.
Movement in the BI 7DRR can also influence the exchange rate. This mechanism is commonly referred to as the exchange rate channel. A rise in the BI 7DRR, for example, will increase the differential between interest rates in Indonesia and other countries. The widening of the interest rate differential will encourage foreign investors to place their capital in financial instruments in Indonesia, such as Bank Indonesia Certificates or SBIs, in order to profit from higher returns. These capital inflows will in turn lead to appreciation in the rupiah. As a result of the rupiah appreciation, imports become cheaper and our exports become more expensive, or less competitive, thus encouraging higher imports while reducing exports. This decline in net exports will then have downward impact on economic growth and activity in the economy.
Changes in the BI 7DRR influence the macro economy through movement in asset prices. Any increase in interest rates will lower prices for assets such as stocks and bonds, thus reducing individual and corporate wealth which in turn diminishes their capacity to engage in economic activities such as consumption and investment.
The impact of interest rate changes on economic activity also influences public expectations of inflation (expectations channel). Any reduction in interest rates seen likely to stimulate economic activity and in turn fuel inflation will encourage workers to anticipate rising inflation by pressing higher wage demands. Manufacturers will then pass on these wages to consumers through higher prices.
This monetary policy transmission mechanism works with a time lag. The time lag may vary, depending on the specific channel. The exchange rate channel normally operates faster, given that changes in interest rates have rapid effect on the exchange rate. Conditions in the financial and banking sector are also heavily influenced by the speed of monetary policy transmission. If banks see that the economy faces considerable risk, the bank response to downward movement in the BI 7DRR will usually be very slow. Furthermore, if banks are undergoing consolidation to improve their capital position, reductions in lending rates and more vigorous credit demand will not necessarily engender an increased lending response. On the demand side, the public may not necessarily respond to lower bank lending rates with increased credit demand if the economic outlook is bleak. In conclusion, the condition of the financial sector, the banking system and the real sector plays a crucial role in the effectiveness or otherwise of the monetary policy transmission process.