100 The Indian Economic Journal • Volume 59(2), July-September 2011
Inflation and Growth Nexus in Indonesia after the
Asian Financial Crisis, 1999-2007
Yulius Pratomo and Kaliappa Kalirajan
This paper aims to examine the inflation and growth nexus in Indonesia after the Asian financial crisis. By using vector autoregressive (VAR) and instrumental variables (IV) model, the results show that there is indirect causality from ‘leader’ provinces’ inflation to ‘follower’ provinces’ growth. Threshold inflation is found to be 2 to 7 per cent. This means that ‘leader’ inflation, between 2 and 7 per cent, improves the positive impact of ‘follower’ provinces’ inflation on ‘follower’ provinces’ growth. Therefore, maintaining low inflation is crucial to support economic growth. Policy implications of this study are: first, Bank Indonesia’s policy to keep inflation between 4 and 6 per cent is appropriate; second, the Government of Indonesia needs to target inflation not only at the national level, but also at regional level, especially for ‘leader’ provinces to be 2 to 7 per cent per year. Consequently, inflation may be targetted differently for both ‘leader’ and ‘follower’ provinces.
I. Introduction
Monetary policy has become important since two major economic crises, i.e., the Asian financial crisis and the global financial crisis deteriorated inflation and growth in many countries. All affected countries suffered because of high inflation and growth sharply declined. Therefore, inflation and growth should be maintained at appropriate levels (Arato, 2009).
Moreover, a better understanding of the relationship between inflation and growth will help monetary authorities to set up the target inflation. In our view, target inflation is the level of inflation which supports growth. To target inflation, therefore, monetary authorities estimate threshold inflation. Threshold inflation can be found by maintaining inflation and growth nexus. Threshold inflation suggests at what level inflation can support and hinder growth (Singh and Kalirajan, 2003). Empirical evidence, furthermore, suggests that low inflation rates tend to support economic growth until they reach threshold inflation, while high inflation rates (i.e., inflation higher than its threshold) tend to hinder growth (Gylfason and Herbertsson, 2001; Burdekin et al., 2004).
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Yulius Pratomo, Satya Wacana Christian University, Indonesia. E-mail: yulius.pratomo@staff.uksw.edu
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