Inflation Dynamics in Indonesia: Equilibrium Correction and Forward-Looking Phillips Curve Approaches

Insukindro Insukindro, Gumilang Aryo Sahadewo


A series of relatively high inflation characterize Indonesian economy, especially during the economic crisis. Economists generally agree that high inflation is one of the major economic problems, and that economic authorities need to cope with such a problem. Therefore, it is essential to understand the behavior of inflation in Indonesia. The aim of this paper is to estimate the inflation dynamics in Indonesia using equilibrium correction and forward-looking Phillips Curve approaches. Previous empirical studies show that the equilibrium correction or backward-looking approach may explain the inflation dynamics in Indonesia. The backward-looking specification does not have to be the proper model even if the fact shows that the specification holds. The major innovation of this paper is the application of a forward-looking Phillips curve model. The empirical results—estimated using the Generalized Method of Moments (GMM)—show that the forward-looking Phillips Curve approach dominates the backward-looking behavior. It indicates that after a credible monetary policy announcement, for instance, the former model predicts that economic agents will change their behavior quickly. Therefore, the policy will affect the economy more rapidly


correction; forward-looking; GMM; inflation; Phillips curve


Adrison, V. 2002. The effect of money supply and government expenditure shock in Indonesia: Symmetric or asymmetric? Working Paper 02/18. Georgia State University Andrew Young School of Policy Studies

Anglingkusumo, R. 2005. Money-inflation nexus in Indonesia.Discussion Paper 054/4. Tinbergen Institute.

Bardsen, G., O. Eitrheim, E. S. Jansen, and R. Nymoen. 2005. The Econometrics of Macroeconomic Modeling. New York: Oxford University Press, Inc.

Cuthbertson, K. 1988. The demand for M1: A forward looking buffer stock model. Oxford Economic Papers 40: 110-131.

Domowitz, I., and L. Elbadawi. 1987. An error correction approach to money demand: The case of Sudan. Journal of Development Economics 26: 257-75.

Dorich, J. 2009. Forward looking versus backward looking behavior in inflation dynamics: A new test. 43rd Conference of Canadian Economics Association, downloaded from

Engle, R. F., and C. W. Granger. 1987. Cointegration and error correction: representation, estimation, and testing. Econometrica 55: 251-76.

Gali, J., and M. Gertler. 1999. Inflation dynamics: A structural econometric analysis. Journal Monetary Economics 44: 195-222.

Gali, J., M. Gertler, and D. V. Salido. 2001. European inflation dynamics. European Economic Review 45: 1237-1270.

Goodfriend, M. 2004. Monetary policy in the New Neoclassical Synthesis: A primer. Economic Quarterly, Federal Reserve Bank of Richmond (90/3): 21-45.

Goodfriend, M. 2008. The case for price stability with a flexible exchange rate in the New Neoclassical Synthesis. Cato Journal 28: 247-254.

Goodfriend, M., and R. G. King. 1997. The New Neoclassical Synthesis and the role of monetary policy. NBER Macroeconomics Annual: 971-987.

Giese, G., and H. Wagner. 2007. Graphical analysis of the new neoclassical synthesis. Diskussionsbeitrag: 411.

Hansen, B. E., and K. D. West. 2002. Generalized method of moments and macroeconomics. Journal of Business and Economic Statistics 20: 460-469.

Hossain, A. 2005. The sources and dynamics of inflation in Indonesia: An ECM model estimation for 1952-2002. Applied Econometrics and International Development 5 (4): 93-116.

Insukindro. 1992. Dynamic specification of demand for money: A survey of recent developments. Indonesian Economic Journal 1: 8-23.

Insukindro. 1998. Pendekatan stok penyangga permintaan uang: Tinjauan teoritik dan sebuah studi empirik di Indonesia [The buffer stock approach to the demand for money: A theoretical review and an empirical study in Indonesia]. Ekonomi dan Keuangan Indonesia 46: 451-471.

International Monetary Fund (IMF). 2010. International Financial Statistics. International Monetary Fund Website, downloaded January 2010 from

Johansen S. 1988. Statistical analysis of cointegrating vectors. Journal of Economic Dynamic and Control 12: 231-54.

Khan, H., and R. Moessner. 2004. Competitiveness, inflation, and monetary policy. Bank of England Working Paper 246.

Koutsomanoli-Filippaki, A., E. Mamatzakis, and S. Christos. 2008. European Banking Integration Under a Quadratic Loss Function.

McKinnon, J. G., R. Davidson, and H. White. 1983. Tests for model specification in the presence of alternative hypotheses. Journal of Econometrics 21: 53-70.

Pesaran, H. M., and Y. Shin. 1995. Autoregressive distributed lag modeling approach to cointegration analysis. DAE Working Paper Series (9514). Department of Applied Economics University of Cambridge.

Phillips, A. W. 1958. The relation between unemployment and the rate of change of money wage rates in the United Kingdom 1861-1957. Economica 25: 283-299.

Pindyck, R., and D. Rubinfeld. 1998. Econometrics Model and Economic Forecasts (4th ed.). Singapore: McGraw-Hill, Inc.

Price, S., and Insukindro. 1994. The demand for Indonesian narrow money: Long run equilibrium, error correction, and forward looking behavior. The Journal of International Trade and Economic Development 3 (2): 147-63.

Puzon, K. A. 2009. The inflation dynamics of ASEAN-4: A case study of the Phillips curve relationship. Journal of American Science 5 (1): 55-57.

Ramakrishnan, U., and A. Vamvakidis. 2002. Forecasting inflation in Indonesia. IMF Working Paper (WP/02/111).

Rudd, J., and K. Whelan. 2001. New test of the New-Keynesian Philips curve. Finance and Economics Discussion Series (52). Board of Governors of the Federal Reserve System.

Rudd, J., and K. Whelan. 2003. Can new rational expectations sticky-price models explain inflation dynamics. Finance and Economics Discussion Series. Board of Governors of the Federal Reserve System.

Sargent, T. J. 1979. Macroeconomic Theory. Academic Press.

Thomas, R. L. 1997. Modern Econometrics: An Introduction. Addison Wesley.

Tillmann, P. 2005. Does the forward looking Philips curve explain the UK Inflation? Manuscript. Institute of International Economics, University of Bonn.

Verbeek, M. 2008. A Guide to Modern Econometrics (3rd ed.). John Wiley & Sons, Ltd.

Whelan, K. 2005. Topic 7: The New-Keynesian Philips curve. EC4010 Lecture Notes. Downloaded January 2009 from

Williamson, S. D. 2008. Macroeconomics. Pearson Education, Inc.

Wooldridge, J. M. 2001. Applications of generalized method of moments estimation. Journal of Economic Perspectives 15: 87-100.

Zouache, A. 2004. Towards a ‘New Neoclassical Synthesis’? An analysis of the methodological convergence between New Keynesian Economics and Real Business Cycle theory. History of Economic Ideas 12: 95-117.

Full Text:  Subscribers Only


Gadjah Mada International Journal of Business
Print ISSN: 1411-1128)/Online ISSN:2338-7238

Published by
Master of Management, Faculty of Economics and Business, Universitas Gadjah Mada
Jl. Teknika Utara No. 1 Yogyakarta 55281, Indonesia
Phone:+62(274) 562222, 515536 ext.113, Fax.: +62 (274) 564388, 511035. e-Mail:
STT No.: 2011/SK/DITJEN/PPG/SST/1994