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1
2
=
| |
|
\ .
is two-dimension vector,
11, 12,
21, 22,
, 1, 2, ...,
i i
i
i i
i p
= =
(
(
is
( ) 2 2 coefficient matrix and
1
2
| |
=
|
\ .
t
t
is a white noise
vector. In other words:
1)
t
has zero mean,
| |
t
E = 0
2)
t
has constant variance,
'
,
t
t
E t ( =
3) and
t s
are not correlated, for t s .
Equation
t 1 t 1 p t p t
...
= + + + + y y y can be written
as follows:
11, 12, 1 11,1 12,1 11, 2 12, 2 1 1 1 1 2 1 1
21, 22, 2 21,1 22,1 21, 2 22, 2 2 2 1 2 2 2 2
...
p p t p t t t t
p p t p t t t t
y y y y
y y y y
= + + + +
( ( ( ( ( ( ( ( (
( ( ( ( ( ( ( ( (
Two-dimension random vector
t 1 t t 1
..., , , ,...
+
y y y is a stochastic
process vector. A stochastic process vector is stationary if:
1) | | E , t =
t
y
2) ( )( ) | |
- -
cov( , ) E ' ( ), t dan 0,1,2,...
t t h t t h
h h = = =
y
y y y y
III.3 Cointegration Test
J ohansens cointegration test is based on the VAR(p) model of
non-stationary variables. For simpler J ohansen test procedure,
VAR(1) model will be used. Remember that VAR (1) model is
noted in matrix notation:
1 1 t t t
Y Y
= +
In Johansens cointegration test, analysis of variables is not only
focused on the result of VAR equation system (Impulse
Response Function and Variance Decomposition are the most
commonly used, as previously discussed), but also considered a
stepping stone for the next cointegration test, whereby re-
parameterization need to be done from VAR(1) model to Model
Vector Error Correction (VECM(1)).
The Granger theorem ensures the existence of an error correction
representation in a cointegrated regression. Based on this
theorem, equation VAR(1) can be represented in the form of
VECM as follows:
1 1
1 1 2
where:
and
t t t
t t
Y Y
Y Y Y I
= +
= =
This VECM (1) form contains information about short-run and
long-run changes stated by parameter and . This Matrix
will be further used to determine whether regression system
is cointegrated. This is the core of Johansen test procedure in
analyzing the cointegration relationship between observed
variables.
For instance, a component of vector Y
t
is a first order
integration or written as I(1), then Y
t-1
is a linear combination
of variable Y
t-1
I(1). In order to estimate all combination
possibilities from Y
t-1
which results in close correlation with
Y
t-1,
a stationary element, J ohansen uses matrix
characteristics as follows:
1. If Rank()=0, then, there is no cointegration
between variables
2. If Rank()=m (m : the number of variables in
VAR model), then all variables are cointegrated
3. If 0 < Rank() <m, then Rank () states the
number of variables that are cointegrated between
0 and m.
Matrix can be decomposed to =
T
where is speed of
adjutsment and is long-run coefficient matrix so that
T
Y
t-1
up
to m-1 combinations is a cointegrated relationship which
ensures that Y
t
reaches long-run equilibrium. Further, Rank
(
T
) can be determined by calculating eigenvalue from
T
.
1 11 12 13 14 15 1
1 1 1 1 1
2 21 22 23 24
1 1 1
p p p p p
t v t v v t v v t v v t v v t v t
v v v v v
p p p
t v t v v t v v t v v t v
v v v
XRATE XRATE SPREAD FINDEV GROWTH INFLATION
SPREAD XRATE SPREAD FINDEV GROWTH
= = = = =
= = =
= + + + + + +
= + + + +
25 2
1 1
3 31 32 33 34 35 3
1 1 1 1 1
4 41 42 4
1 1
p p
v t v t
v v
p p p p p
t v t v v t v v t v v t v v t v t
v v v v v
p p
t v t v v t v
v v
INFLATION
FINDEV XRATE SPREAD FINDEV GROWTH INFLATION
GROWTH XRATE SPREAD
= =
= = = = =
= =
+ +
= + + + + + +
= + + +
3 44 45 4
1 1 1
5 51 52 53 54 55 5
1 1 1 1 1
p p p
v t v v t v v t v t
v v v
p p p p p
t v t v v t v v t v v t v v t v t
v v v v v
FINDEV GROWTH INFLATION
INFLATION XRATE SPREAD FINDEV GROWTH INFLATION
= = =
= = = = =
+ + +
= + + + + + +
( ) ( )
1 1 1 1 1
1 5 1
...
; ... , 1,..., 1; ...
t t t p t p t
t
t
t i i p p t
t
t
y y y y u
XRATE
SPREAD
y A A i p I A A FINDEV
GROWTH
INFLATION
+
+
= + + + +
| |
|
|
| = = + + = =
|
|
|
\ .
i
From the above mode, a hypothesis can be formulated:
Non-stationary data ; stationary data
0
0
H : 1
(Non stationary data)
H : 1
(Stationary data)
p
i
i
p
i
i
<
Statistical Test:
1
= Dickey Fuller
std. error
p
i
i
p
i
i
| |
|
\ .
Significance: =5%
Decision rule in ADF testing:
If the statistic value is smaller than the Dickey Fuller critical
value, then the null hypotesis is rejected, indicating that the time
series data is stationary.
Table 4.1 Unit Root Test
From the unit root testing, the existence of unit roots in the
research variables indicates that the research data are non-
stationary. With regard to the non-stationary originated data, the
next step is to conduct first difference testing. Results suggest
that the first difference data shown to be significant at the 5%
significance level. This implies that the research variables are
stationary at first difference.
IV.2.2 Lag Length Determination in VAR
In this section, the AIC and SIC criterion are used in determining
the optimal lag length in a VAR model.
Determination of optimal lag used by the researcher in order to
estimate a short run equation is based on Akaike Information
Criterion (AIC). The criterion of optimal lag information can be
seen in Table 4.2 below.
Table 4.2 Optimal lag determination
According to Table 4.2 above, it can be seen that the optimal lag
based on AIC is lag 3.
IV.2.3 Cointegration Test
The purpose of cointegration test is to assess similarities of
movement and relationship stability between variables in a long-
run. When a data series contains a unit root and integrated to the
same order, cointegration test can be performed to assess the
existence of cointegration. In this research, the J ohansens
Cointegration Test method is employed. An influential
relationship can be seen from the cointegration that exists
between variables. When a cointegration exists between
variables, this implies that influential relationship occurs
throughout variables and information is parallelly distributed.
The J ohansens Cointegration Test indicates that a cointegrating
vector exists, or at least a linear independent combination exists
from the variables contained in the model. The consequence is
that alternative hypothesis which states the presence of
cointegration relationship can be accepted.
Table 4.3 Cointegration Test
Cointegration test result indicates that research variable has
long-term relation. It can be concluded that the next step of
analyzing short-run analysis between research variable in long-
term can be executed.
In long-term specification model, several restrictions were
imposed in a long-term equation parameter. First, in the long-
run, there is no relationship between inflation and output. This is
supported by the Phillips Curve theory that shows a
relationship/trade-off between inflation and short-run output. In
other words, in short-run, the economy has to bear the cost and
the inflation if higher economic growth is required. This is
clearly shown in the Phillips curve below.
Figure 4.8 Short-run Phillips Curve
Source: Robert J . Gordon, Macroeconomics, 10th edition, 2006,
Addison-Wesley
Secondly, there is no long-term relationship between exchange
rate depreciation and economic growth. Traditional views such
as elasticity approach, absorbance and Keynesian approach
argue that exchange rate depreciations have positive effect on
output. Elasticity approach states that depreciation will boost
trade balance when Marshall Lerner condition is fulfilled.
Keynesian approach, where output is assumed to be below
potential output, full employment states that exchange rate
depreciation will positively impact on output and employment.
However, the monetary approach argues that exchange rate
depreciations influence real magnitudes especially through the
influence of real balance in the short-run, but leave all variables
constant in the long-run (Domac, 1997).
Third, there is no long-run relationship between financial
development and inflation. The increase in bank lending will
boost the total amount of money in circulation. According to
Quantity Theory of Money, expansion in money supply results
in inflation. In monetary view, the elevation in total amount of
money in circulation encourages the elevation of aggregate
demand and excess demand, leading to increase in price level
and wages, whereby this mechanism only happens in short term.
Table 4.4 Estimation of VECM Long-Run Model
The Likelihood Ratio Test is done to assess the appropriateness
of parameter restrictions in a long-run equation. The value with
2-degree of freedom and is observed. It can be concluded that
the data support parameter restrictions set in the long-run
equation.
IV.2.4 VECM Long-Run Model
In the long-run (with the use of cointegrating vectors
interpretation), the following model can be constructed:
Theoretically, the signs located in each variable are logical and
rational. From the economic growth equation above, it can be
seen that financial deepening FINDEV is positively related to
economic growth GROWTH. This supports the supply leading
hypothesis asserted by Patrick (1996) where financial
intermediaries transfer resources by collecting funds and
mobilizing savings to be directed and used for investment
purpose. This is in line with funding innovation concept
proposed Schumpeter (1911).
SPREAD is negatively related to GROWTH. The increase in
spread between credit interest rate and interest rate policy
indicates the increased risk in an economy. This reflects the
vulnerability of financial system to shocks. In other words,
financial system is in an unstable condition, giving pressure to
output.
( )
( )
GROWTH(-1) 26.95074+0.509185 FINDEV -1 3.948655 SPREAD(-1)
[-2.57882] [ 8.00248]
INFLATION -1 13.79273 0.985913 SPREAD(-1) 0.015158 XRAT
=
= +
| | | |
E(-1)
2.09635 0.33260
According to the inflation equation, SPREAD is negatively
related to GROWTH. Financial instability shown by increasing
risk in financial system reduces inflation rate. This is relevant in
high risk situation where market responds by declining
purchasing power, resulting in the reduction of aggregate
demand.
Furthermore, XRATE positively influences INFLATION. The
exchange rate depreciation directly increases money supply, the
increasing in money supply reduces interest rate. The decline in
interest rate promotes investment and aggregate demand. While
the excess demand results in elevation of price and wages,
thereby, resulting in high inflation rate.
IV.2.5 VECM Short-Run Model
Table 4.5 Estimation of VECM Short-Run Model
From Table 4.5 above, it can be seen that all short-term
corrected coefficients heading towards long-term equilibrium
(ECT/Error Correction Term) show negative sign and significant
at 99% confidence level. This indicates that the model used is
stable enough and is in line with the basic theory. The ECT
coefficient for short-run growth dynamics also shows statistical
significance with negative result. The negative sign on ECT
coefficient shows that the VEC model is a backward model
where short-run imbalance will be corrected towards long-run
imbalance, according to information accommodated within ECT
variables. Besides that, in short-run, economic growth is also
influenced by the growth itself and inflation; while implied risk
premium and inflation are the main contributing factors of short-
run inflation dynamics.
IV.2.6 Impulse Response Function
An impulse response function states the effect of one standard
deviation shock to one of the innovations on current time values
and future values of endogenous variables. A shock from
endogenous variable directly influences the variable itself, which
then influences other endogenous variables through the dynamic
structures of VAR and VEC. IRF provides direction and
magnitude of the effect between endogenous variables as it
demonstrates the influence of one-standard deviation
endogenous variable shock on other endogenous variables and
the variable itself. Therefore, with new information coming up,
any shock that occur in a variable, will affect the variable itself
and other variables in a system. Impulse Response Function on
research variables for 10 upcoming period is presented below.
Figure 4.9 Impulse Response Function
Responses of economic growth to inflation, financial sector
development, implied risk premium and exchange rate
depreciation shocks.
From Figure 4.9 above, GDP growths positive response is
evident on a standard deviation shock to credit volume. This
positive relationship supports the theory stating that increasing
credit volume stimulates the real sector economy, which further
increases output. On the other hand, GDP growth responses
negatively to a standard deviation shock to spread (implied risk
premium) and exchange rate. The elevation of interest spread
(implied risk premium) reduces investment and creates pressure
in economic growth. This occurs permanently up to the 36th
month.
Figure 4.10 Impulse Response Function
Responses of inflation to economic growth, financial sector
development, implied risk premium and exchange rate
depreciation shocks
Figure 4.10 shows the response of inflation towards shocks in
credit volume, spread and exchange rate. The increase in credit
volume distributed to banks is responded positively by inflation,
with the increased in inflation rate. This occurs as a direct impact
on increasing capital resource in real sector, resulting in greater
money supply in the society. Higher money supply negatively
affects price level stability (higher inflation rate).
The elevation of interest spread (implied risk premium) is also
negatively responded by price stability. Increasing risk level
indicated by widening interest spread reduces investment climate
in a country which forces the reduction of real interest rate.
Therefore, assuming ceteris paribus, output level declines or in
other words, economic recession occurs. In recession, deflation
commonly takes place.
IV.2.7 Variance Decomposition
Table 4.6 Variance Decomposition of Economic Growth
Table 4.6 above shows us that on the first period, the forecast
error variance of GROWTH explained by the GROWTH itself is
85%. In 36 months, the forecast error variance explained by
GROWTH decreases to 6%. It is evident that economic growth
is highly influenced by the implied risk premium and financial
development which describe each forecast error variance of
growth of 57% and 30%. The exchange rate depreciation and
inflation only influences economic growth in short-run. This also
indicates that the data support the restriction imposed in the
long-run equation.
Table 4.7 Variance Decomposition of Inflation
From table 4.7 above, it is observed that on the first period, the
forecast error variance of INFLATION explained by the
INFLATION itself is reported to be 73%. At the beginning of
period, there has been marked influence from GROWTH
variable of 17.04%, decreasing in 36 months, where GROWTH
only contributes 2% of the forecast error variance from
INFLATION. This is in line with the short-run Phillips Curve
theory which illustrates short-run trade-off between economic
growth and inflation. Up to the 36th month, the forecast error
variance of INFLATION is described by FINDEV, SPREAD
and XRATE contributing 44%, 25% and 20%, respectively. This
indicates that in the long-run financial development, implied risk
premium and exchange rate depreciation influence monetary
stability (inflation).
V. CONCLUSION AND RECOMMENDATIONS
5.1 Conclusion
This research is conducted to understand the relationship
between financial sector dynamics, inflation and economic
growth in Indonesia. It can be concluded that:
1. A positive relationship is evident between financial
deepening and economic growth, while negative
relationship is observed between financial system
stability and economic growth
a. This is shown by the VECM Model which
illustrates that in a long-run, financial
deepening and financial system stability
influence economic growth.
b. According to the estimated results of Impulse
Response, a positive shock of financial
deepening is positively responded by the
increasing economic growth for 36 months. On
the other hand, a positive shock of implied risk
premium (spread), exchange rate depreciation
and inflation are negatively responded by the
economic growth.
2. Negative relationships are evident between financial
system stability and monetary stability (inflation) as
well as exchange rate depreciation and inflation
Variance Decomposition of GROWTH
Period S.E. XRATE SPREAD FINDEV GROWTH INFLATION
1 4.675623 1.224627 12.25342 0.65976 85.86219 0
6 10.77995 0.578441 49.0602 0.487891 46.3697 3.503765
12 14.16866 0.137386 66.84135 9.413768 18.79081 4.81669
18 16.69339 0.095708 64.7816 19.24083 10.56299 5.318876
24 18.4802 0.17359 61.08808 25.08083 7.72892 5.928587
30 19.92642 0.279459 58.84812 27.88405 6.578549 6.409827
36 21.25784 0.357925 57.7011 29.21874 5.999509 6.722718
Cholesky Ordering: XRATE SPREAD FINDEV GROWTH INFLATION
Variance Decomposition of INFLATION
Period S.E. XRATE SPREAD FINDEV GROWTH INFLATION
1 0.282013 0.180058 8.867256 1.010217 17.04958 72.89289
6 1.092094 9.970768 36.06197 4.610009 9.809208 39.54804
12 1.74729 10.64549 43.48506 23.87836 3.53918 18.45191
18 2.222245 13.00937 36.525 35.37426 2.501613 12.58976
24 2.588447 15.80549 31.13252 40.33962 2.27741 10.44496
30 2.905923 18.03045 27.92656 42.63289 2.083341 9.326761
36 3.200221 19.5112 25.98069 44.08262 1.910189 8.515301
Cholesky Ordering: XRATE SPREAD FINDEV GROWTH INFLATION
a. This is shown by the long-run model that
financial system stability and exchange rate
depreciation influences inflation rate.
b. According to the estimated results of Impulse
Response, inflation positively responses a
positive shock of financial deepening, and
negatively responses implied risk premium
(spread) and exchange rate depreciation.
3. A positive relationship is observed between economic
growth and inflation.
According to the estimated results of Impulse
Response, inflation positively responses a positive
shock in economic growth.
5.2 Recommendations
This research investigates the relationship between financial
sector dynamics, inflation and economic activities. In the past
two decades, there have been substantial changes in Indonesian
financial sector. Several deregulations occurring in financial
sector markedly impact on macroeconomic condition, especially
on the economic growth.
Nations economy is highly determined by its financial
development because financial sector held a very important role
in performing its intermediary role. Therefore, banking sector
need to be supported to improve the provision of productive
investment credit, while upholding the risk management
principle in its operation. With emerging investment projects,
there will be a surge in demand of financial products such as
lending. Hence, interactions between monetary sector and real
sector need to be encouraged to drive Indonesias economy. In
order to optimize credit distribution to the real sector, there is a
need of solid coordination between Bank Indonesia as monetary
authority and the government as the fiscal authority, in
minimizing asymmetric information that occur in credit market.
Besides, the government is also expected to develop policies
which creates conducive business environment with regard to
several economic issues in cost, law enforcement and
infrastructures in order to attract new capital investment.
In relation to the procyclicality in Indonesian economy, Bank
Indonesia is expected to coordinate with the government as a
fiscal policy authority in supporting countercyclical
macroeconomic policy. This is essential in avoiding potential
risk if the economy turns to procyclicality. Moreover, monetary
and fiscal policy authority should implement risk management
guidelines in designing policy framework. In other words,
macroeconomic policies developed by Bank Indonesia and the
government are expected to consider all potential risks that may
occur in the nations economy, which in turn support financial
system stability, monetary stability and stimulates sustainable
economic.
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