Central Bank Policy: Theory and Practice

ISBN: 978-1-78973-752-3, eISBN: 978-1-78973-751-6

Publication date: 25 July 2019


Warjiyo, P. and Juhro, S.M. (2019), "Prelims", Central Bank Policy: Theory and Practice, Emerald Publishing Limited, Leeds, pp. i-xvi.



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Central Bank Policy

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Praise for Central Bank Policy: Theory and Practice

The book rigorously discusses the theories, empirical studies and practices of international financial and monetary policy in emerging market economies, including Indonesia. Furthermore, the book is an invaluable policymaking input for the central bank and government, teaching material for lecturers and students as well as an important reference for scientific development in academia.

Prof. Boediono, Vice President of the Republic of Indonesia (2009–2014); Governor of Bank Indonesia (2008–2009)

The world has become increasingly challenging for central banks in both developed and emerging economies. While much has been written on central banks policies in the developed world, less known are the remarkable successes achieved by central banks in the emerging economies. This publication is a valuable source for policy makers in central banking. It not only offers knowledge on the theoretical foundations and institutional arrangements but also on the practical aspects of the policy tools that are at the disposal of central banks, particularly in the emerging world.

Dr Zeti Akhtar Aziz, the 7th Governor (2000–2016) of Bank Negara Malaysia, Malaysia’s central bank

This book is a major contribution to the theory and practice of central banking in emerging market economies. Drawing on the accumulated wisdom of many years of academic study and high-level policy experience, the authors provide an encyclopedic yet highly accessible survey and analysis hat bridges theory and practice. No stone is left unturned in this comprehensive study, drawing as it does on economic history, the international monetary system, globalization, and the political economy of macroeconomic policy making.

The volume will be invaluable for a wide audience, including advanced undergraduate and graduate students, academic researchers, policy makers, financial market analysts, and anybody with an interest in contemporary macroeconomic challenges and issues. A highly recommended publication.

Prof. Hal Hill, H.W. Arndt Professor Emeritus of Southeast Asian Economies, Australian National University

When a pure academic writes a book, it lacks practical knowledge and connections; when a pure policy maker writes a book, it lacks academic rigor; but, when an academic who is also an experienced policy maker writes a book, the resultant is a balanced book. It is this balance that the literature lacks and for this reason alone this book, by two experienced academics who have decades of central banking policy making experience, will remain unique.

This book is an amalgam of theoretical percepts, empirical case studies and practical policy debates. While existing reference material would either be too empirical or too theoretical and almost always short of practical policy discussions, this book is far from it. A gap in the history of central banking policies and practices is now immaculately covered. It makes understanding central banking policies and practices easy. The book is both inspirational and thought-provoking. The value and impact of this book will be long lasting.

Prof. Paresh Kumar Narayan, Alfred Deakin Professor, Deakin University

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Central Bank Policy: Theory and Practice


Perry Warjiyo and Solikin M. Juhro

United Kingdom – North America – Japan India – Malaysia – China

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Emerald Publishing Limited

Howard House, Wagon Lane, Bingley BD16 1WA, UK

First edition 2019

Copyright © 2019 Emerald Publishing Limited

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No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use.

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN: 978-1-78973-752-3 (Print)

ISBN: 978-1-78973-751-6 (Online)

ISBN: 978-1-78973-753-0 (Epub)


List of Figures ix
List of Tables xi
About the Authors xiii
Preface xv
Part I General Review
Chapter 1 Introduction 3
 1.1. The Central Bank and Economy 4
 1.2. Central Bank, Academic Thinking, and Political Economy 6
 1.3. Objectives of the Book 9
 1.4. Systematics of the Writing 10
 1.5. Utility of the Book 16
Chapter 2 Central Bank Evolution and Reform 19
 2.1. Introduction 19
 2.2. The Evolving Role of the Central Bank 20
 2.3. Central Bank Policy Reform 31
 2.4. Central Bank Institutional Reform 39
 2.5. Concluding Remarks 44
Part II Monetary Policy and Economy
Chapter 3 The Role of Money and Monetary Policy in the Economy 49
 3.1. Introduction 49
 3.2. Theoretical Review 50
 3.3. Empirical Evidence and Related Issues 63
 3.4. Market Imperfections and the New Paradigm of Monetary Economics: Credit Matters 69
 3.5. Concluding Remarks 78
Chapter 4 Exchange Rates and the Economy 81
 4.1. Introduction 81
 4.2. Exchange Rate Determination Theory 82
 4.3. Empirical Findings for Exchange Rates and the Economy 98
 4.4. Exchange Rate System and Policy 101
 4.5. Concluding Remarks 112
Chapter 5 Monetary Policy Transmission Mechanism 115
 5.1. Introduction 115
 5.2. Monetary Policy and the Transmission Mechanisms 116
 5.3. Monetary Transmission Channels: The Money View 124
 5.4. Monetary Transmission Channels: The Credit View 129
 5.5. Monetary Policy Transmission in Various Countries 140
 5.6. Concluding Remarks 157
Part III Monetary Policy Framework
Chapter 6 Monetary Policy Strategic Framework 161
 6.1. Introduction 161
 6.2. Conceptual Dimension and Theoretical Models 162
 6.3. Empirical Studies and Related Issues 170
 6.4. Implementation in Several Jurisdictions 176
 6.5. The Monetary Policy Regime in Indonesia (1968–1998) 186
 6.6. Concluding Remarks 190
Chapter 7 Monetary Policy Operational Framework 193
 7.1. Introduction 193
 7.2. Conceptual Dimension and Theoretical Models 194
 7.3. Application in Several Countries 205
 7.4. Monetary Operations in Indonesia 216
 7.5. Concluding Remarks 220
Chapter 8 Inflation Targeting Framework: Concept and Implementation at Central Banks 223
 8.1. Introduction 223
 8.2. Conceptual Dimension and Theoretical Model 224
 8.3. Institutional and Operational Framework 234
 8.4. Inflation Targeting Regimes 247
 8.5. Inflation Targeting and Economic Performance 252
 8.6. Concluding Remarks 259
Chapter 9 Inflation Targeting Framework: Implementation in Indonesia 261
 9.1. Introduction 261
 9.2. Institutional Framework 263
 9.3. Operational Framework 266
 9.4. Evolution Thus Far 271
 9.5. Strengthening the ITF Implementation Strategy after the Global Financial Crisis 277
 9.6. Concluding Remarks 281
Appendix 9.1: Amendments to the Bank Indonesia Act and their Implications 283
Appendix 9.2: Bank Indonesia Macroeconomic Models 287
Part IV Institutional Aspect of Central Bank Policy
Chapter 10 Monetary Policy Credibility and Time Consistency 291
 10.1. Introduction 291
 10.2. Conceptual Dimension of Policy Credibility 293
 10.3. Theoretical Model Concerning the Policy Credibility Problem: Time Inconsistency 298
 10.4. Empirical Studies: Measures of Credibility and Time Inconsistency 306
 10.5. Assessing Monetary Policy Credibility in Indonesia 311
 10.6. Concluding Remarks 318
Chapter 11 Central Bank Independence and Accountability 319
 11.1. Introduction 319
 11.2. Conceptual and Empirical Dimensions of Independence and Accountability 320
 11.3. Theoretical Models Concerning Independence and Accountability 327
 11.4. Empirical Studies and Related Issues 337
 11.5. Bank Indonesia’s Independence and Accountability 344
 11.6. Concluding Remarks 346
Chapter 12 Policy Transparency and Communication Strategy 349
 12.1. Introduction 349
 12.2. Conceptual Dimension of Policy Transparency and Communication Strategies 350
 12.3. Theoretical Models on Policy Transparency: Conservative Central Bank and Imperfect Transparency 365
 12.4. Practices and Empirical Studies of Transparency and Communication Strategies in Different Countries 370
 12.5. Transparency and the Communication Strategy in Indonesia 380
 12.6. Concluding Remarks 384
Part V New Paradigm of Central Bank Policy
Chapter 13 Monetary Policy and Foreign Capital Flows 387
 13.1. Introduction 387
 13.2. Theoretical Dimension and Foreign Capital Flow Developments 388
 13.3. Foreign Capital Flows and Economic Performance 395
 13.4. Foreign Capital Flows and Monetary Stability 400
 13.5. Foreign Capital Flow Management: Theories and Practices 409
 13.6. Concluding Remarks 417
Chapter 14 Macroprudential Policy and Financial System Stability 423
 14.1. Introduction 423
 14.2. Conceptual Dimension of FSS 424
 14.3. Theoretical Model and Empirical Evidence of Financial Procyclicality 435
 14.4. Theoretical Model and Empirical Evidence for Interconnectedness and Financial Networks 444
 14.5. Macroprudential Policy Theory and Practices 452
 14.6. Concluding Remarks 459
Chapter 15 Central Bank Policy Mix 461
 15.1. Introduction 461
 15.2. Conceptual Dimension of the Central Bank Policy Mix 463
 15.3. Structural Macroeconomic Modeling: Integrated Inflation Targeting 473
 15.4. DSGE Modeling with Macrofinancial Linkages 486
 15.5. Bank Indonesia Policy Mix 502
 15.6. Concluding Remarks 514
Bibliography 517
Index 553

List of Figures

Figure 3.1: Bank-optimal Rate. 73
Figure 3.2: Market Equilibrium Loanable Funds. 73
Figure 3.3: Equilibrium Credit Rationing. 74
Figure 4.1: Exchange Rate Determination Theory. 83
Figure 4.2: Policy Analysis in the Mundell–Fleming Model. 86
Figure 4.3: Policy Analysis According to Dornbusch’s Overshooting Model. 90
Figure 4.4: Analysis of Monetary Operations in the Portfolio Balance Model. 92
Figure 5.1: Monetary Policy and the Transmission Mechanism118
Figure 5.2: Business Decisions without Collateral Constraints. 136
Figure 5.3: Business Decisions with Collateral Constraints. 136
Figure 6.1: Demand-side Shocks: Targeting Prices and Nominal Income. 165
Figure 6.2: Supply-side Shocks: Targeting Prices and Nominal Income. 166
Figure 6.3: Output Loss Linked to Disinflationary Policy. 176
Figure 10.1: Indifference Curve of the Time Inconsistency Problem. 300
Figure 10.2: Policy Strategy and the Social Cost. 303
Figure 10.3: Core and Headline Inflation Trends. 312
Figure 11.1: Output Stabilization Preference Behavior. 331
Figure 11.2: Monetary Policy Behavior (c > 0). 335
Figure 11.3: Monetary Policy Behavior after Lowering c. 336
Figure 11.4: Monetary Policy Behavior after Lowering h. 337
Figure 11.5: Ex Post Accountability and Central Bank Reaction. 341
Figure 12.1: Measuring the Transparency Index using the Guttman Scale. 376
Figure 13.1: Aggregate GDP Per Capita of Capital Exporters (Weighted Current Account). 396
Figure 13.2: Foreign Capital Flows to EMEs and Developing Countries (Annual Average in Billions of USD). 397
Figure 13.3: Monetary Policy Trilemma. 402
Figure 14.1: Linkages between Macro–Micro Policy and FSS. 428
Figure 14.2: Financial Cycle and Economic Cycle Procyclicality. 436
Figure 14.3: Incomplete Networking. 445
Figure 14.4: Disconnected Network. 445
Figure 14.5: Complete Network. 446
Figure 14.6: Interconnectedness through Three Banks. 448
Figure 14.7: Money Center Network. 449
Figure 14.8: UK Banking Network. 450
Figure 14.9: Global Banking Network. 450
Figure 15.1: Integration of the Monetary Policy and Macroprudential Policy Framework. 468
Figure 15.2: Macroprudential and Monetary Policy: Maintaining FSS in the Cyclical Dimension. 471
Figure 15.3: Monetary and Macroprudential Policy Mix Cycle Maintains Macroeconomic and Financial System Stability in a Cyclical Dimension. 482
Figure 15.4: Coordination and Losses after a Demand Shock. 486
Figure 15.5: Coordination and Losses after a Supply Shock. 487

List of Tables

Table 6.1: The Central Bank’s Legal Monetary Policy Framework. 180
Table 6.2: Average Economic Growth and Inflation in Several Countries from 1991 to 2014 (%). 181
Table 7.1: Monetary Policy Operational Targets (2015). 206
Table 7.2: Monetary Policy Instruments in Several Countries (Until 2004). 210
Table 7.3: US Monetary Policy Reaction Function. 213
Table 8.1: Characteristics of Inflation Targeting. 227
Table 8.2: Provisions in Central Bank Laws. 235
Table 8.3: Price Indexes Used. 237
Table 8.4: Inflation Target: Point or Range. 238
Table 8.5: Inflation Target Horizon. 239
Table 8.6: Announcing the Inflation Target. 240
Table 8.7: Inflation Targeting Regime Classification. 251
Table 9.1: Actual and Target Inflation. 276
Table 11.1: Central Bank Personal Independence. 324
Table 11.2: Central Bank Accountability. 326
Table 11.3: Central Bank Independence and Accountability Index. 327
Table 12.1: Monetary and Financial Policy Transparency Index by Country. 373
Table 12.2: Economic Forecast Publication Profile of Central Banks. 375
Table 12.3: Transparency and Inflation: Correlation Analysis. 377
Table 12.4: Transparency and Output Volatility: Correlation Analysis. 377
Table 13.1: Global Foreign Capital Flows (% of GDP). 391
Table 13.2: Determinants of Foreign Capital Flows: Push Versus Pull Factors. 394
Table 13.3: Monetary Policy Trilemma Index in Indonesia. 407
Table 13.4: A Decomposition of the Dynamic Correlation between Exchange Rates Versus Foreign Capital Inflows and Interest Rates. 407
Table 14.1: Examples of Macroprudential Policy Instruments. 432
Table 14.2: Interaction between the Business Cycle, Risk-taking Behavior and the Financial Cycle. 438
Table 14.3: Macroprudential Instruments Applied in Asian Countries. 454
Table 14.4: Macroprudential Instruments: Types and Risk Dimensions. 458
Table 15.1: Effect of Monetary Policy of FSS. 472
Table 15.2: Integration of Price Stability and FSS: Three Modeling Approaches. 475
Table 15.3: Central Bank Framework: Integrated Inflation Targeting. 478
Table 15.4: Three Approaches to Model Financial Frictions in DSGE. 489
Table 15.5: Four Cases of Price Stability and Financial System Stability. 506

About the Authors

Dr. Perry Warijiyo is currently the Governor of Bank Indonesia. Before serving as Governor, he was the Deputy Governor of Bank Indonesia (2013–2018). Previously, he also served as the Assistant Governor for monetary, macroprudential, and international policies. Dr Perry also held the prestigious position of Executive Director of the International Monetary Fund (IMF), representing 13-member countries in the South-East Asia Voting Group (2007–2009). He has a long, impressive, and outstanding career serving Bank Indonesia since 1984. His contributions have been primarily in economic and monetary policy research, international issues, organizational transformation and monetary policy strategies, education and research on central banks, and management of foreign reserves and external debts. Significantly, also, he has been the Editor-in-Chief of Bank Indonesia’s flagship journal, the Bulletin of Monetary Economics and Banking. He is also an active Postgraduate Lecturer at the University of Indonesia and at several top ranked universities in the country. In addition, he has authored and published a number of books, journals, and papers on economy, monetary, and international issues. He has offered numerous high-level keynote speeches that have influenced public policy. He received his Bachelor’s degree from Gajah Mada University, Indonesia, and Master’s and Ph.D. degrees in International Monetary Economics and Finance from Iowa State University, USA.

Dr. Solikin M. Juhro is an Executive Director and the Head of Bank Indonesia Institute, Bank Indonesia. In his distinguished career at Bank Indonesia spanning more than 20 years, he has been extensively involved with monetary economic policy research and analysis, has spoken on academic and central banking issues at various national and international fora, and is an instrumental Editor of the Bank Indonesia flagship journal, the Bulletin of Monetary Economics and Banking. His current research focuses on macroeconomic transformation, central bank policy, and frontier issues in economic development, some of which have been published international outlets. Dr Juhro is currently a member of the SEACEN Advisory Group for Macroeconomic and Monetary Policy Management, representing Bank Indonesia. He was active in the Pacific Economic Outlook Structural Specialist projects in Osaka, Japan, from 2005 to 2015. He is also an active Postgraduate Lecturer at the University of Indonesia. He completed his Bachelor’s degree in Economics at the Airlangga University, a Master’s degree in Applied Economics at the University of Michigan, Ann Arbor, USA, a master’s degree in Economics at the University of Maryland, College Park, USA, and a doctoral degree in Economics (with cum laude) at the University of Indonesia, Indonesia.


Alhamdulillah, with all praise to Allah, the most glorified and exalted, we would like to present this book entitled Central Bank Policy: Theory and Practice to the readers, drawing fully on our extensive capabilities, knowledge, and experience to write a book that, to our understanding, does not exist elsewhere, at least in Indonesia. This book also represents an important contribution to central bank and government policymaking as well as teaching materials for lecturers and students and a salient reference for scholarly development in Indonesia and internationally.

The idea for the book emerged from the experiences and concerns of the authors while teaching postgraduate international monetary and financial economics at the University of Indonesia. The teaching materials presented consist of a combination of theoretical studies, empirical reviews, and policy practices at central banks, which garnered an enthusiastic response from the students. Not only could the students explore and deepen the latest theories being developed in academia and empirically model the most interesting research topics, the inclusion of policy practices at central banks also embedded the students into the real world. Consequently, the courses were enlivened by interesting questions and discussions that enriched and enhanced the quality of the teaching.

Unfortunately, we were unable to find a single reference book complete with a combination of theoretical studies, empirical reviews, and policy practices at central banks, thereby motivating us to write this book. This was, admittedly, no mean feat due to the rapid development of policy theories and practices at central banks as well as the fact that most of the materiel had not yet appeared in print as a reference for this book. Fortunately, we could draw on our vast experience and direct involvement with policymaking at Bank Indonesia (BI) as well as our active roles as resource persons or discussants at various international fora. Additionally, one of the author’s two-year tenure as Executive Director at the International Monetary Fund from 2007 to 2009 coincided with the global financial crisis, which further served to enrich the understanding and knowledge poured into this book, including the BI policy mix initiated in 2010 as a new policy paradigm at the central bank.

This book is firmly believed to be a first in terms of comprehensively discussing the latest central bank policy theories and practices. The inclusion of the latest material, coupled with clear and logical systematics of the writing, ensures this book’s position as an unequivocal reference for policymakers at the central bank, practitioners, and academia. For academia, the book represents an important and leading reference for lecturers and students alike in terms of monetary and financial economics at the intermediate and advanced levels of master’s and doctoral programs as well as the latter stages of bachelor’s programs. The panoply of theoretical and empirical references contained in this book will facilitate future research among students and researchers. Similar benefits will also be available to economists and those in the business community. Although the discussions are predominantly on a philosophical conceptual level, accompanied by in-depth theory, the rationale and writing of this book is presented in a manner that is readable and easily digestible.

To remain relevant and contemporary, the materials contained in this book will periodically be updated as per the latest developments and requirements in terms of new and innovative policy practices at the central bank. To that end, constructive criticisms and feedback from the readers are warmly welcomed in order to hone the contents of this book.

In closing, the authors would like to acknowledge the important contributions, direct and indirect, of various parties to produce this book. On top of the gratitude felt for the publication of this book, the authors would also like to thank the contributors who could not be named individually, particularly colleagues at the BI Institute for their help in finalizing the book. Hopefully, this publication will expand scientific understanding and knowledge.

Perry Warjiyo, S.E., M.Sc., Ph.D. and Dr Solikin M. Juhro, S.E., M.A.E., M.A.

Jakarta, October 2018