The Narrow Money Demand Behaviour in Indonesia, 1970-2005

This paper specifies a simple partial adjustment model of narrow money demand for Indonesia in an open economy context and estimates it with annual data for the period 1970-2005. Empirical results suggest that real income, inflation (a proxy for expected inflation), and the return on foreign financial assets are the major determinants of narrow money demand in this country. The deposit rate of interest (a proxy for the interest rate on alternative domestic financial assets) is statistically insignificant. The CUSUM and CUSUMSQ of residuals' tests suggest that the narrow money demand function remained stable during the sample period of study. Having selected an empirically parsimonious model, both the recursive and rolling regression techniques are applied to investigate the possibility of structural change in the regression coefficients possibly due to financial reforms and innovations since the early 1990s. Empirical results suggest that since the late 1990s the long-run income elasticity of the demand for narrow money has remained relatively stable around a value not different from one while the narrow money demand elasticities with respect to the rates of inflation and the return on foreign financial assets have declined markedly. The paper interprets the overall empirical results in a historical context and draws implications on the strategy of monetary policy in Indonesia.