Inflation differentials, determinants, and convergence: Evidence from Indonesia subnational data

This paper is aimed to examine co-movements and heterogeneity in inflation dynamics of different regions across Indonesian provinces to improve the understanding of the nature of inflation characteristics in the context of the Indonesian monetary union. Having employed a factor analysis approach, our model is able to decompose regional inflation dynamics that are explained by country wide and district (zone) specific factors as well as an idiosyncratic local factors. An interesting finding here is that common (national) factors are almost equally important together with local (regional) factors in explaining sources of inflation differentials across Indonesian economies. The second objective of this study is to investigate determinant factors of regional inflation differentials, and our findings suggest that the differences are mainly related to their structural economic characteristics namely economic structures, market competition, degree of openness, cost of input factors, and local specific factors. Given the fact that the significances of those local variables in explaining regional inflation variations may assert that economic integration within Indonesia is currently still difficult, considering that its geography are vastly distributed throughout regions, while its infrastructure and connectivity conditions are limited. The final objective of this study is to examine long run convergence of regional inflations, and in turn our model is able to find and show the existence of convergences. Overall, this paper illuminates the importance of disaggregate regional inflation information, as summarised by the local factors, in explaining aggregate national inflation rates, even after conditioning on macroeconomic variables. Accordingly, the relevant policy actions and coordinations based on subnational and local level play a vital role in enhancing the effectiveness of the monetary policy conducts in Indonesia that is primarily directed to targeting inflation.