The Optimal Instrument Rule of Indonesian Monetary Policy

Since 1999, according to Law No. 23/1999, Bank Indonesia (BI–the Indonesian Central Bank) set inflation targeting as the goal of its monetary policy. At the time, BI set monetary aggregate M1 as its operational instrument. However, as BI considers M1 to be increasingly difficult to control, it has changed its operational instrument to the nominal interest rate. The changes are stipulated in Law No. 3/2004. This paper discusses the optimal value of interest rate as the operational instrument of Indonesian monetary policy, known as the optimal instrument rule. An instrument rule is defined as a single mathematical expression indicating the value of interest rate (as a policy instrument) the Central Bank should set. Previous examples of instrument rules are the well-known Taylor rule and McCallum rule. The instrument rule in this paper is constructed by applying a mathematical model which is then tested empirically by using an econometric method. The period of estimation for the policy instrument in the model is the quarterly monetary data from 1993 to 2006.