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6 min readJan 30, 2022

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What are the determinants of the effectiveness of monetary policy in Indonesia

Monetary policy is the process of regulating a country’s money supply to achieve certain goals, such as holding back inflation, achieving full employment or being more prosperous. Monetary policy can involve setting standard loan interest rates, “margin requirements”, capitalization for banks or even acting as a last-ditch borrower or through negotiations with other governments.

Monetary policy is basically a policy that aims to achieve internal balance (high economic growth, price stability, equitable development) and external balance (balance of payments balance) and the achievement of macroeconomic objectives, namely maintaining economic stability which can be measured by employment opportunities, stability international prices and balance of payments.

If stability in economic activity is disturbed, then monetary policy can be used to restore it (stabilization measures). The effect of monetary policy will be felt first by the banking sector, which is then transferred to the real sector. Monetary policy is an effort to achieve a high level of economic growth in a sustainable manner while maintaining price stability.

To achieve this goal, the Central Bank or Monetary Authority tries to regulate the balance between the money supply and the supply of goods so that inflation can be controlled, full employment opportunities are achieved and smooth supply or distribution of goods is achieved. Monetary policy is carried out, among others, by one of but not limited to the following instruments, namely interest rates, minimum statutory reserves, intervention in the foreign exchange market and as a last resort for banks to borrow money in case of liquidity problems.

The determinants of the effectiveness of monetary policy are basically determined by two things, namely the elasticity of investment spending to the interest rate and the elasticity of demand for money to the interest rate.

The term monetary policy itself has a meaning, namely decisions taken by the government in order to support economic activity by determining the amount of money circulating in the community.

According to Law no. 23 of 1999 concerning Monetary Policy of Bank Indonesia, the main objective of monetary policy is to maintain stability and availability of money in a country.

In fact, it is not only monetary policy that is useful for the Indonesian economy. There are also other policies, such as fiscal policy, discount policy, and so on. Before discussing the determinants of the effectiveness of monetary policy, first identify what is meant by monetary policy and its objectives.

About Monetary Policy

Quoting from the official website of Learning Resources: Ministry of Education and Culture, monetary policy is a government action that affects the economy by determining the amount of money in circulation.

There are two types of monetary policy, namely expansionary monetary policy and contractionary monetary policy, see the explanation below:

1. Ekspansive Monetary Policy

Expansive monetary policy, often called easy money policy, is a policy that regulates the amount of money supplied to the economy. This is done by lowering interest rates, buying government securities by the central bank, and lowering reserve requirements for banks. Expansive policies will also reduce the unemployment rate and stimulate business activity or consumer spending activities.

Overall in all countries, the objective of expansionary monetary policy is to increase economic growth with the risk of higher inflation. Expansive monetary policy is primarily to increase the money circulating in the community so that the wheels of the economy run faster. This policy is able to increase people’s purchasing power (demand) and reduce the number of unemployed when the economy experiences a recession or depression. Expansive monetary policy also affects the unemployment rate in a country.

For example, expansionary policies are usually applied to reduce unemployment because the availability of large amounts of money will stimulate business activities so that the labor market is getting bigger. With fiscal authority, the central bank controls the exchange rate of the domestic currency (Rupiah) against foreign currencies. A concrete example is that Bank Indonesia increased the money supply by issuing more printed notes. The Rupiah currency is cheaper than the currencies of other countries.

Learn about other monetary policies in Indonesia through the case studies discussed in the book Monetary Economics by Prof. Dr. Haryo Kuncoro, S.E., M.SI.

2. Kebijakan Moneter Kontraktif

Contractive Monetary Policy is a policy in order to reduce the money supply. This policy is carried out when the economy experiences inflation. Also known as a tight money policy. Contractive monetary policy (monetary contractive policy) called tight money policy is a policy of reducing the money supply.

The main objective of this policy is to reduce the inflation rate. The objective of contractionary monetary policy is to reduce the money supply in the economy. This goal can be achieved by increasing interest rates, selling government bonds, and increasing reserve requirements for banks.

Examples of Monetary Policy in Indonesia Some examples of monetary policies that have been implemented in Indonesia are as follows: Bank Indonesia (BI) conducts an auction of its certificates, or it could be through the purchase of securities in the capital market. UBI may lower interest rates if economic conditions meet expectations. On the other hand, BI can raise interest rates if it wants to limit economic activity so that the flow of money is reduced.

When the economy is in a recession, the money supply will increase so that economic activity will increase. An example is buying securities (securities). When inflation occurs, BI will reduce the flow of money to the public by selling securities to reduce excessive economic activity.

Prof. Dr. Ali Wardhana as the Governor of the World Bank and the International Monetary Fund revealed how hard it was for him to escape from the pressure of formulating developed countries’ policies in the global economic crisis which was discussed in Prof.’s book. Dr. Ali Wardhana: Monetary and Fiscal Policy Reformer in Indonesia.

There are also objectives of the monetary policy carried out by the government, one of which is to ensure economic stability, as stated in Law no. 3 of 2004 concerning Bank Indonesia Monetary Policy.

More fully, here are the objectives of monetary policy.

  • Controlling inflation
  • Increase employment
  • Protecting the stability of the price of goods in the market
  • Maintaining the balance of international payments
  • Encouraging economic growth

Monetary Policy Instruments

  • Open Market Operations Policy

This is one of the policies taken by the central bank to reduce or increase the amount of money currently circulating in the community by buying or selling Bank Indonesia Certificates (SBI) or by buying or selling securities sold in the capital market.

  • Discount Policy

Discount is the government reducing or increasing the money supply by changing the discount of commercial banks. If the central bank considers the money supply has exceeded demand (a symptom of inflation), the central bank issues a decision to raise interest rates. Raising interest rates will stimulate people’s desire to save.

  • Cash Reserve Policy

The central bank can make regulations to increase or decrease cash reserves (cash ratio). Commercial banks, accept money from customers in the form of demand deposits, savings, time deposits, certificates of deposit, and other types of savings. There is a certain percentage of the money deposited by the customer and may not be lent.

  • Interest rate adjustment

The central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is the interest rate charged by the central bank to banks for short-term loans. For example, if the central bank increases the discount rate, the cost of borrowing for the bank increases.

Furthermore, banks will increase the interest rates they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

Determinants of the Effectiveness of Monetary Policy

Previously, it has been explained that there are two determinants of the effectiveness of monetary policy, namely the elasticity of investment spending to the interest rate and the elasticity of money demand to the interest rate.

Check out the full explanation below, as quoted from the page book Learning Resources: Ministry of Education and Culture compiled by Rusdi Rustandi, namely:

  1. Elasticity of investment spending on the interest rate

That is, the effect of changes in interest rates on the level of investment. The more elastic investment spending on the interest rate, the more effective monetary policy will be.

This is because a decrease in the interest rate can add a sizeable investment, so the relationship between the interest rate and the investment rate can be said to be inversely proportional.

2. The elasticity of the demand for money with respect to the interest rate

That is, the effect of changes in interest rates on the demand for money. If the demand for money is elastic to the interest rate, then monetary policy is increasingly ineffective.

On the other hand, the more inelastic the demand for interest rates, the more effective monetary policy can be.

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