The role of aggregate demand shocks in explaining Indonesian macro-economic fluctuations

Abstract

A variant of the Mundell-Fleming model of the Indonesian macroeconomy is constructed and analysed using the SVAR methodology. The short run relations among the variables in the model are identified through the use of contemporaneous restrictions. The long run relations are developed by imposing restrictions related to (i) a long-run money demand equation and (ii) a modified McCallum (1994) policy reaction function on the cointegration matrix. The smallness of the economy is acknowledged by restricting appropriate elements of the loading matrix. Most of the estimated parameters of short run as well as long run relations, and the shape of impulse response functions, are consistent with small open economic theory. The model produces richer dynamics of the variables compared to a similar SVAR study of the macroeconomy of Indonesia. Our strategy of explicitly incorporating transmission mechanisms for aggregate external shocks, imposing the two long run restrictions and acknowledging the smallness of the economy allows greater (smaller) role for shocks to aggregate demand (supply) to affect macroeconomic fluctuations.