The shape of the Phillips curve: the case of Indonesia

Abstract

It is recognized that the effectiveness of monetary policy in the control of inflation depends critically on the relationship between inflation and the output gap. During booms, inflation is highly sensitive to monetary influences, but during recessions this influence is considerably muted. However, econometric investigation of this phenomenon has mostly focussed on the developed economies. In this article, the shape of the Phillips curve is investigated for Indonesia. Evidence is found of significant nonlinearities in the inflation–output relationship for Indonesia and it is argued that this relationship is best modelled by the capacity-constraint (L-shape) model.

Keywords:

• Phillips curve
• nonlinear
• Indonesia

JEL Classification::

• C22
• E31
• E51
• E58

Acknowledgements

We are grateful for fruitful comments from Prof. Peter Howells and participants of the INFER conference held in Stirling (Scotland, UK), 4–6 September 2009. The constructive suggestions of an anonymous referee are also gratefully acknowledged. All errors, however, are our own. Any opinions expressed are those of the authors and not those of Bank Indonesia.

Notes

¹  is referred to as the ‘wall’ parameter because it determines the value at which the functional relationship between inflation and the output gap effectively becomes vertical.

² A positive value indicates appreciation of the Rupiah while a negative value means a depreciation of the Rupiah.