BALANCING A PARSIMONIOUS AND COMPLEX MODELBALANCING A PARSIMONIOUS AND COMPLEX MODEL

IN EMERGING MARKET ECONOMIES:

CASE OF INDONESIACASE OF INDONESIA

(General Equilibrium Model of Bank Indonesia - GEMBI)

Prepared for Structural Dynamic Macroeconomic Models

In Asia-Pacific Economies Workshop

Bali, June 3-4,2008

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Economic Modeling & Outlook Group, Bureau of Economic Research,Directorate of Economic Research and Monetary Policy

B A N K I N D O N E S I A

The increasing needs of DSGE in Emerging Market 

Many central banks have increasingly been interested in DSGE modelMany central banks have increasingly been interested in DSGE model to guide their monetary policy formulation for some reasons :

DSGE has strong micro‐foundation  all economic agents maximize their objective function subject to their constraint.h b h i f i i d h b i f i lThe behavior of economic agents is constructed on the basic of rational expectation  monetary policy formulation is influenced by expectation (forward looking)Endogenous policy rule in the DSGE model  some variablesof monetary g p y ypolicy (interest rate) and fiscal policy (tax) are determined with in the  model.DSGE model is able to generate economic steady state in the long run owing to dynamic optimization principle of economic agentsowing to dynamic optimization principle of economic agents . 

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Issues on DSGE Implementation in Emerging Marketin Emerging Market 

• Market imperfection   price and wage rigidity, adjustment cost, financial market disintermediation and excess liquidity modelfinancial market disintermediation and excess liquidity  model become more complicated

• The credibility of monetary and fiscal authorities are still weak  the standard model based on full credibility has to be adjusted.F it l bilit d t f ll i t i i k t d t• Free capital mobility does not fully exist in emerging market due to numerous types of exchange rate arrangements such as managed floating and fixed exchange rate system and some degree of capital control.

• Different economic structure   economic sector model become more relevant  to capture the specific and dominant sector  the model has to more disaggregated.

• Statistical data required to estimated parameter in emerging market is less accurate, reliable and availability as compared to developedless accurate, reliable and availability as compared to developed countries.

• Therefore the construction DSGE model  in emerging market should consider the specific features of emerging market economies .

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Trade off between Parsimonious and Complex Model

• The bigger the scale of the model the larger the b f b dnumber of parameters to be estimated, estimation is

more complex.

Th bi th l f th d l t i i• The bigger the scale of the model transmission mechanism is more complex (black box).

• The bigger the scale of the model more difficult to• The bigger the scale of the model more difficult to communicate the result to the policy makers.

• The bigger the scale of the model more complicatedThe bigger the scale of the model more complicated model the result often can not explain real world phenomena.

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Specific Features of Indonesia DSGE Model: GEMBI

GEMBI has 6 economic agents:1. Household Indonesian household is heterogeneous:

GEMBI

g- Life-time consumers (capitalist) - Hands-to-mouths consumers (non capitalist).

2. Firms: agriculture sector is very important in Indonesia- Economic sector : Finished goods non-agriculture producers and Agriculture g g p g

producers- Production process : Finished good, intermediate producers, and Importers

3. Financial Institutions/Banks Indonesian Banks are not fully perfect competitionneed adjustment/transaction cost.

4 Fiscal Authority4. Fiscal Authority - Non Ricardian Model (current consumption consider budget deficit)- Government expenditure consider ratio debt to GDP maximum 60%

5. Monetary Authority:Endogenous policy rule Inflation forecast based output gap Taylor Rule- Endogenous policy rule Inflation forecast based output gap Taylor Rule

- Stock of SBI (Central Bank Certificate) is endogenous to capture excess liquidity6. Rest of the World (external sector)

- Uncovered interest rate parity is not fully hold (imperfect capital market)Capital account current account and foreign exchange reserve are endogenous

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- Capital account, current account and foreign exchange reserve are endogenous.

Emerging Market Imperfection

IMPERFECTION OF ECONOMIC AGENTS (ADJUSTMENT COST)

Application in GEMBI model

• The preference of all economic agent consider opportunity cost• Type of adjustment cost:

- Transaction costs (consumption activities) cash vs non cash- Adjustment cost (investment activities) time to build - Real cost function (bank activities) cost to manage deposit and

credit• Objectives of adding adjustment cost:

– Better short-run dynamics– Greater flexibility in controlling speed of adjustmenty g p j– Consistent with long-run equilibrium

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Emerging Market Imperfection

IMPERFECTION IN LABOR MARKET (WAGE RIGIDITY)

Application in GEMBI model

( )• Labour market in Indonesia is not flexible (rigid) the

existence of wage rigidity market clearing doesn’t fully workwork.

• Rigidity in labour market can generate wage inflation that further explain the dynamics on labour market.p y

• Due to wage rigidity we can have better short-run output and inflation dynamics.

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Emerging Market Imperfection

IMPERFECTION IN EXTERNAL SECTOR

Application in GEMBI model

1. Interest Parity is not sufficient to explain the dynamics of exchange rate in Indonesia need to add risk premium variable in the modelvariable in the model.

2. Interest Parity is not sufficient to explain the movement of capital flows need to add cost of portfolio.p p

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INTERACTIONS AMONG ECONOMIC AGENTS IN COMPLEX GEMBIAGENTS IN COMPLEX GEMBI

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BANKS AS ONE ECONOMIC AGENT IN COMPLEX GEMBI

Banks maximizes profit with respect to its asset and liabilities

COMPLEX GEMBI

, , B

t t s i ss t

Max E β∞

=

Π∑Constraint (Bonds, Deposit and Loans)

( ) ( ) ( )( ) ( )

*, , 1 , 1 1 1

* * *1 1 1 1 1 1 1

1 1 1

(1 )(1 ) 1 1 ( , )

Bt B t t t B t t B R t t B t t t

Bt t t B t lt t B R dt t t t t t

B Sbi e B Loan D i B i Sbi

i e B i Loan i D P AC Loan D

α α

θ α α− − − −Π + + + + − − − = + + +

+ + + + + − − − + −

Where  is the cost of portfolio adjustment,

2⎛ ⎞

( ) ( )1 1 , 1 1 1 1 1( )( ) ( , )t t t B t lt t B R dt t t t t tCθ α α− − − − − − −( , )B t tC Loan D

21( , )2

B L t D tt t

t t

Loan DC Loan D

P A⎛ ⎞Ω −Ω

= ⎜ ⎟⎝ ⎠

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FISCAL AND MONETARY AUTHORITY IN COMPLEX GEMBI

• Constraint for Fiscal Authority (transfer, subsidy, and foreign debt)

COMPLEX GEMBI

*, , , 1 , 1

* * *1 1 , 1

(1 )

(1 )(1 )

c dG t t G t t t t COM t t t t G t

Ct t t G t c t t w t t t

B e L PG s P COM Trf i B

i e L P C W Lθ τ τ τ− −

− − − Π

+ = + + + +

+ + + − − − Π

• Constraint for Central Bank ( Currency Reserves and outstanding SBI)• Constraint for Central Bank ( Currency, Reserves and outstanding SBI)

( )* * *1 , 1 , 1 1 1 1 1 1(1 ) (1 ) (1 )t t CB t t CB t t t t t t t t t R t tX X B i B e R i e R Sbi i Sbi D Dα− − − − − − − −− = − + + − + − + + − −

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Need for more parsimonious model?p

Need for a simplified version, thus SIMPLE GEMBI

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Transmission Mechanism of simple GEMBIp

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GEMBI simulation for monetary policy :Imported Inflation Shock

1. Measuring monetary policy response to an

p

g y p y pinflation shock as well as its impact to economic growth and exchange rate.

2 I fl ti h k i d 3% t f it 2. Inflation shock is assumed 3% on top of its steady state value of 6%.

3 In this simulation BI-rate is an endogenous 3. In this simulation, BI-rate is an endogenous variable as a function of inflation deviation from its target and output deviation from its potential value (Taylor rule).

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GEMBI simulation for monetary policy :Imported Inflation Shockp

3% inflation shock (from 6% to 9%)100 bp increase in BI-Rate during 2008

10.0%

8.0%

9.0%

rate

5 0%

6.0%

7.0%

Infla

tion

100 bp response of BI Rate will bring inflation rate

4.0%

5.0%

2008

-II00

8-IV

2009

-II00

9-IV

2010

-II01

0-IV

2011

-II01

1-IV

2012

-II01

2-IV

2013

-II01

3-IV

2014

-II01

4-IV

2015

-II01

5-IV

2016

-II01

6-IV

2017

-II01

7-IV

p p gdown to its initial value in a year

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2 20 2 20 2 20 2 20 2 20 2 20 2 20 2 20 2 20 2 20

BI rate increase 100bp

GEMBI simulation for monetary policy :Imported Inflation Shock and

interest rate response

3% inflation shock (from 6% to 9%)3% inflation shock (from 6% to 9%)100 bp increase in BI-Rate during 2008

9.25%

9.50%

9% (Q3-08 & Q4-08)

8 50%

8.75%

9.00%

st ra

te

8.75% (Q1-09)

8.5% (Q2-09)

8.00%

8.25%

8.50%

Inte

re 8.25% (Q3-09)

8% (Q4-09)

7.50%

7.75%

008-

II00

8-IV

009-

II00

9-IV

010-

II01

0-IV

011-

II01

1-IV

012-

II01

2-IV

013-

II01

3-IV

014-

II01

4-IV

015-

II01

5-IV

016-

II01

6-IV

017-

II01

7-IV

8.75%(Q2-08)

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20 20 20

20 20

20 20

20 20

20 20

20 20

20 20

20 20

20 20

20

BI rate increase 100bp

GEMBI simulation for monetary policy :Imported Inflation Shock and impact on

economic growth

3% inflation shock (from 6% to 9%)( )100 bp increase in BI-Rate during 2008

6 2%

6.3% 6.2%

5.9%

6.0%

6.1%

6.2%

Gro

wth

6%

5 5%

5.6%

5.7%

5.8%

Econ

omic

G

5.7%

100 bp response of BI rate will drive down economy growth to 5.7% (Q2-08) followed by an increase to 6.2% (Q3-09) during one year and eventually back its steady state

l f 6%

5.3%

5.4%

5.5%

08-II

8-III

8-IV

09-I

09-II

9-III

9-IV

10-I

0-II

0-III

0-IV

11-I

1-II

1-III

1-IV

12-I

2-II

2-III

2-IV

% value of 6%

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200

2008

2008 20

020

020

0920

09 201

201

201 0

2010 20

120

120

1 120

11 201

201

201 2

2012

BI rate increase 100bp

GEMBI simulation for monetary policy :Imported Inflation Shock

and impact on exchange rate

3% inflation shock (from 6% to 9%)100 bp increase in BI-Rate during 2008

9450

9250

9350

e R

ate

9271 Rp/USD 9254

Rp/USD

9050

9150

9250

Exch

ang

100bp response of BI rate will keep exchange rate relatively stable with small apreciation trend due to huge interest rate differensial

8950

9050

008-

II08

-III

08-IV

009-

I00

9-II

09-II

I09

-IV01

0-I

010-

II10

-III

10-IV

011-

I01

1-II

11-II

I11

-IV01

2-I

012-

II12

-III

12-IV

differensial

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20 200

200 20 20 200

200 20 20 201

201 20 20 201

201 20 20 201

201

BI rate increase 100bp

Conclusion

• Although we moved to simple GEMBI some emerging market features are ll d ( d dstill maintained (open economy, production stages, price and wage 

rigidity, and import dependant nature of economy)

• Simple GEMBI had been used to simulate monetary policy response for• Simple GEMBI had been used to simulate monetary policy response for various shocks such as : exchange rate appreciation, imported inflation shock and review of medium term inflation target  

H bl i h• However, some problems are persist, such as :– Some theoretical‐inconsistent simulation (need for TA)– Unsatisfactory forecast result (need for TA)

Communication to policy makers– Communication to policy makers

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THANK YOUTERIMA KASIHTERIMA KASIH

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