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This paper aims to investigate the impact of exchange rate depreciation and money growth to the consumer price index (CPI) inflation in Indonesia.

Using threshold model applied to Phillips curve equation.

Using monthly data from 1980:1 to 2008:12, the econometric evidence shows that there are indeed threshold effects of money growth on inflation, but no threshold effect of exchange rate depreciation on inflation. Even though the threshold value for exchange rate depreciation is found at 8.4 percent, the F-test suggests that there is no significant difference between the coefficient below and that above the threshold value. While two threshold values are found for money growth, i.e. 7.1 and 9.8 percent, and they are statistically different. The impact on inflation is high when money grows by up to 7.1 percent, it is moderate when money grows by 7.1-9.8 percent, and it is low when money grows by above 9.8 percent.

This research is using methodology proposed by Hansen which the threshold is based on the minimum SSR. The value of SSR will differ from one model to one model. For example, model using quarterly data will give the different result from that using monthly or yearly data. Also, when the author uses the new data, the result could be different.

Even though inflation targeting framework has been adopted by Bank Indonesia (BI) since 2005, BI should not disregard the monetary aggregate variable, especially M1. This is because the growth of money is still matter to influence inflation in the short run. The impact on inflation is found to be larger than the impact of exchange rate depreciation when it is below a certain threshold value.

This is the first paper that evaluates the threshold effect of exchange rate and money growth in emerging country, especially in Indonesia.

The purpose of this paper is to evaluate the performance of six types of policy rules applied for Indonesia, using monthly data spanning January 1980 to December 2008.

This paper uses deterministic simulations on a small macro model and evaluates the policy rules based on the loss function.

Among six types of policy rules, an inflation forecast‐based rule with contemporaneous output gap (IFBG) is found to be the most efficient rule for Indonesia. The rule suggests that the central bank should react strongly to inflation deviations from the target, react moderately to the output gap and smooth the interest rate. The optimal horizon is 3‐4 quarters. Including the exchange rate in the policy rule causes deterioration in economic performance.

No previous study examines Indonesia employing the same methodology.