How and How Much
Can Monetary Policy Stabilize
the Impacts of Climate Change
Shocks Preemptively?
The Indonesian Case
August 2008
John Junggun Oh
Director of Research, South East Asian Central Banks, Research and Training Centre (The SEACEN Centre)
Impacts of Climate Change Shocks
• A decrease in the potential capacity of growth
– A decline in capital stocks, labor supply, and total factor productivity
• A rise in the inflation rate
– an increase in the import prices of food and then, as a consequence, a rise in wage rate
• A decrease in capital inflows
Climate Change Effects on
Incorporation of Climate Change Shocks
into the Monetary Policy Framework
Climate changes
→ potential growth
→ global economic growth→ current account →economic growth
→exchange rate
→ capital flows→ potential growth output gap
→exchange rate →current account→ economic growth
→ interest rate → economic growth
interest rate
→inflation
→ global food price (with ex. rate) →domestic food price→ wage →inflation inflation
Monetary Policy Framework
New Keynesian Model
• Policy reaction function of the central bank
int=c(1)+c(2)* (infla(2)-inflatarget) +c(3)*gdpgaprate(1) +c(4)*lnex+c(5)*(( infla(2)-inflatarget)* gdpgaprate(1))+c(6)*int(-1)
• Non-linear Phillips curve
infla=c(7)+ c(8)*gdpgaprate(-2)+c(9)*gdpgaprate(-2)^2+c(10)*lnwage
(-1)+c(11)*lnwage(-2)+c(12)*lnimp(-1)+c(13)*lnex(-3)+c(14)*infla(-1)
• IS curve
Other Equations
to incorporate Climate Changes
• Wage rate equation
lnwage=c(19)+c(20)*gdpgaprate(-1)+c(21)*lnfoodd(-4)+c(22)*lnwage(-1)
• Domestic food price equation
lnfoodd=c(23)+c(24)*lnex(-1)+c(25)*lnfoodg(-1)+c(26)*lnfoodd(-1)
• Current account equation
ca=c(27)+c(28)*lngdp(-3)+c(29)*lngdpg(-3)+c(30)*lnex(-4)+c(31)*ca(-1)
• Import price equation
lnimp=c(37)+c(38)*lnex+c(39)*lnfoodg(-1)+c(40)*lnimp(-1)
• Exchange rate equation
Simulation
(2008~2011)
• Baseline without Climate Change Shocks
• Simulation with Climate Change Shocks <Assumptions>
– World food price increases by 20% from 2008 to 2009, 30 % from 2010, and
40% in 2011 against the baseline forecast.
– World real GDP decreases by 2 % from 2008~2011 against the baseline
forecast.
– Indonesian real potential GDP decreases by 1% from 2008~2011 against the
6000
Exchange Rates by Scenario
ex_actual ex_baseline ex_senario
Due to an assumed decrease in capital inflows,
Indonesian rupiah is
forecasted to be depreciated
in contrast to the expected
appreciation of the baseline scenario
c u rre n t a c c o u n t/g d p ra tio b y s c e n a rio current account is expected to
improve in the short-term
compared with the baseline scenario current account forecast,
but, due to the assumed
slowdown of the global economy,
its trend is expected to
long--10
GDP Gap Rate by Scenario
gdpgaprate_actual gdpgaprate_baseline gdpgaprate_senario
Due to the declining trend of the current account,
the GDP gap rate is
forecasted to record
considerable minus level,
2
Inflation Rate by Scenario
In spite of shrinkage of demand due to the
considerable minus GDP gap rate,
the inflation rate is forecasted to show an increasing trend, in contrast to the expected declining trend in the baseline scenario, due to a high rise in domestic food prices resulted from the
assumed surge in world food prices
Inflation Target Rate by Scenario
increasing trend of the inflation rate,
due to the
considerable minus GDP gap rate,
the level of the target rate of inflation could be maintained at the higher level
compared with the baseline scenario target rate of
0
Interest Rate by Scenario
As a
consequence,
the level of the interest rate is forecasted to maintain at the slightly lower level
Exchange rate policy
• Exchange rate policy, for instance,
appreciation of Indonesian rupiah, could be
recommended to contain the rising inflation
pressure,
• but in this case, the forecasted declining
Identification of the optimal target rate of
inflation and the target rate of interest
• The levels of data of the simulation results may not be exactly correct since the simulation was done based on the relatively simple assumptions.
• The results show that climate change shocks will provide the central bank with very tough challenges
– how to keep the commitment to price stability on the one hand and how much to take the possible worsening economic growth and employment into account.
• It will be important issues for the central bank to identify the optimal target rate of inflation and the target rate of interest to harmonize the rising inflation and declining economic growth,
Monetary Policy Guidelines for Climate Change
Shocks
• First round impacts of climate change shocks on the economy, in particular, impacts on the potential capacity of growth, world economic growth, world food prices, and capital flows, if necessary, in consultation with environmental specialists.
• Second round impacts on exchange rates, domestic food prices, wage rates, import prices and inflation rates on the one hand, and the current account, economic growth on the other hand.
• The optimal target rate of inflation based on the studies on the impacts on the growth and inflation rate,
• Ultimately preemptive forecast of GDP gap rate and inflation gap, which are important variables for the formulation of the monetary policy.
Core inflation rate
• Since climate change shocks are largely supply-side shocks, it could be desirable to examine whether core inflation rate or underlying rate of
inflation excluding foods and energy prices could be a reference indicator of the inflation rate for the monetary policy.
– Core inflation rate may be useful to overcome the limitations of the monetary policy as a short-term demand management stabilization policy, in particular, in the period of rising food prices
• If the difference between the headline inflation and core inflation is considerable, and the public has no deep understanding on the core inflation rate,
