Dsge Model With Banking Sector: The Case Of Indonesia

A well-functioning financial system is necessary for an effective monetary policy transmission. Simultaneously, monetary policy can also influence financial system stability through its effect on financial condition and behavior of the financial market. Changes in policy rate will have an effect on how agents in financial markets perceived the future prospect of the economy and will influence their spending/investment decisions. Despite this, Blanchard et al (2010) argues that the policy rate is not an appropriate tool to deal with many financial system imbalances, such as excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. As an example, they stated that increasing policy rate to deal with excessively high asset price will result in undesirably higher output gap. They proposed that macroprudential policy such as cap on loan-to-value ratio to be employed to address these specific financial system imbalances. We develop a small open economy DSGE model with financial frictions and banking sector as in Gerali (2010). We modified the banking sector balance sheet from Gerali’s model to include risk free assets and reserves, in addition to bank’s loan to households and entrepreneur, as part of bank’s asset portfolio choices. This is in accordance to the current condition of Indonesian (aggregate) bank’s balance sheet which includes a significant amount of excess liquidity held in a form of risk free asset such as Bank Indonesia’s Certificates (SBI) and Government’s Bonds (SBN). The main focus of the research is to understand the transmission mechanism of loan to value (LTV) ratio requirement policy and how it will interact with monetary policy. Based on the model simulation, an increase in LTV ratio requirement for households’ lending will lead to an increase in consumption and housing asset accumulation of the constrained households. This will lead to a higher growth of aggregate demand and inflation. In order to increase households’ lending, the bank reduces the amount of risk free asset from its portfolio and will cause an increase in its loan to deposit ratio (LDR). In addition, allocating more assets with higher interest rate will also increase bank’s profit that will lead to an increase in its capital. A higher growth in aggregate demand will increase inflationary pressure and will prompt central bank to increase the policy rate. The same dynamics applied to an increase in entrepreneur’s LTV ratio requirement. Entrepreneurs will increase their consumption and investment because of the increase in funding they acquired from the bank. This will lead to an increase in GDP. Because the increase in GDP is mostly comes from the higher growth of investment, inflationary pressures is not as significant as in the previous case but central bank still need to respond by increasing policy rate. See above See above