ALTERNATIVE OF MONETARY POLICY INDICATOR: PANEL DATA

ANALYSIS FROM ISLAMIC BANKS IN INDONESIA

CHAPTER 1
1.1 Background.
Economic growth is one of the measurement variables of a country to be
known as developed country, If the economy of the country is stable it can be
concluded that the country is developed. However, if it’s the opposite then the
country can’t be considered as a developed one. In order to encourage the
development of economy a country must capable to keep the improvement of
economic activities continuously.

In macroeconomic analysis, Gross Domestic Product (GDP) is the

measurement tool of a country to measure its economy. through GDP, a country
can measure income and expenses flows of its economic condition in a certain
period. Economic growth is related with the economic activities in the society,
mainly related with the improving process of a goods and services production. in
order to measure the economic growth, it is necessary to use GDP value which is
the one that based of constant price (real GDP). Therefore, it can be seen that the
produced numbers of growth are the real growth that is caused by the increment of
production. the existence of balance in economy is one of the goals of a country to
reach its economic development. And those balance can be realized through
economic variables which are possibly affected or give impact to it.

To be able to create a high and continuously economic growth, central bank

or monetary authority must struggle to manage and keeping the balance between
currency stability towards goods and services and currency stability towards foreign
currencies. These efforts are conducted in order to reach full employment and
maximising the distribution of a country.

Economy with its stability will be more interested rather than economy with
a shocks and fluctuations. Economic stability of a country will be more supportive
to the economic growth of the country itself. Economic stability is capable to give
pressure to inflation and balancing the money supply in society. One of the
indicators to measure the economic stability is through analysing the performance
and stability of macroeconomy namely the money supply, investment, interest rate,
and inflation.

Indeed, one of the policies that could be used to improving and keeping the
sustainable economic growth in Indonesia is through monetary policy. Monetary
policy is one of the policies that can be used to solve economic problems, by the
main intention is to keep the stability of the currency (rate of rupiah). This monetary
policy could also be a tool to managing the flows of the economy especially
controlling the macroeconomy in order to work properly based on the instruments
and indicators of monetary policies that had been determined by the policy makers.

In a scope of macroeconomy policy, financial sector can be a tool to the

transmissions of monetary policy, which referred to the authority of monetary
policy in a certain country which related with monetary issues. Those wisdoms can
be defined as the policies that referring to controlling the financial institutions,
actively selling and purchasing the bonds by the monetary authority in order to give
impact to the transmission of the monetary condition, passively selling and
purchasing the bonds which were caused by keeping a certain interest rate, stock
price stability, and to fulfilling the certain responsibility and commitment.

Generally, the policies that conducted by the monetary authority are actually
for affecting the monetary variables, such as money supply and the interest rate.
Basically, the intention of monetary policy is to reach the internal and external
balance. For the internal balance, it’s usually referring to creating the stability of
employment and achieving the high economic growth which can maintaining the
inflation in low ebb. (Insukindro, 1997)

The monetary policy is an important factor in an economy. however, recall

that in our country Indonesia is implementing the dual economic system, namely
the conventional perspective and Islamic perspective which obviously based on
Islamic principles. In that case it does not rule out the possibility to the monetary
system to have different perspective as well.
 In conventional monetary system, is based on money supply theory which
were stated by John Maynard Keynes (1936). Keynes stated that money demand is
encouraged by transaction needs, predicting the future (urgent), and for livelihood
needs through purchasing bonds. This theory still being adopted by a lot of countries
until this current time.

In this principle, the monetary system is trying to create a macroeconomic

condition where it can support the economic growth, keeping the price stability, and
controlling the inflation. The effort of controlling the inflation is conducted through
managing the amount of money supply, base-money more specifically.

If the condition of economy is facing a high inflation, then what the

monetary can do is to decreasing the money supply in society. This effort is also
known as the monetary contractive policy. If the condition is the opposite, then the
monetary system will be trying to increase the money supply by intent to attract the
society to do more economic activities, this effort is known as the expansive
monetary policy.

But the question is how exactly the policy maker decide to what kind of
monetary policy that could give a positive impact and may supporting the economic
growth? What kind of variables that they used as their indicators to make monetary
policy?

Many studies had explored the similar subject. First following the example
of Friedman and Schwartz [1963], Romer and Romer [1989] reintroduced the
“narrative approach” where he actually trying to separate amount of money supply
from the money demand shock. But unfortunately, this approach doesn’t seem to
be able to clearly distinguish the endogenous and exogenous components of policy
change, which is necessary for identifying the effects of monetary policy on the
economy. Boschen and Mills [1991] has also tried to conduct a similar subject
which give a stress on reducing unemployment and reducing inflation. Ev en
Boschen and Mills seems to be able to give more continuous and informative
measurement than Romer. Their indicator seems to be suffering in the same
problems.
 Other studies have also tried to find an alternative indicator through
information of central bank operating procedures, which is using vector
autoregression (VAR) estimation techniques. Such as Bernanke and Blinder [1992].
Which in their studies they have stated that funds rate may compatible to be the
indicator to build a monetary policy. Similarly, to Sims [1992] which in his studies
he stated that short-term rates can be utilized as the monetary policy indicator.
Nevertheless, not all researchers had the same conclusion with those statement even
though they conducted a similar estimation technique. Thornton [1988], Christiano
and Eichenbaum [1992] they argued that the quantity of non-borrowed reserves is
more compatible to be utilized as the indicator of monetary policy. Strongin (1995).
Has stated that the fed has its limit to supply the total reserve demand in the short
run. However, it can effectively tighten the policy by reducing nonborrowed
reserves and forcing banks to borrow more from the discount window. Sheehan
[1994] characterized federal policy as borrowed reserves targeting, which suggest
that borrowed reserves might useful indicator for the more recent period.

The latest studies by Zuriyati and Abdul [2018] through analysing Islamic
banks in Malaysia. They have stated that the appropriate indicator for monetary
policy is through future growth of nominal GDP. They suggest that this future
growth of nominal GDP is compatible and could be utilize by the central bank to
obtain an early indication of the impact of monetary policy especially in a country
which implementing dual banking system and more importantly it is in conformity
with Islamic teaching.

1.2 Research Question.

The objective of this study is to find out whether that the future growth of
nominal GDP is compatible and appropriate to be utilized as the alternative
indicator for Islamic Monetary system in Indonesia.
 CHAPTER 2

2.1 LITERATURE REVIEW

Role of Monetary policy in developing country.

Generally, the monetary policy in developing country is way heavier than the one
in developed country. There are some factors that becomes the reason why the
monetary policy in developing country is way heavier. First, the responsibility to
keep the stability of money demand so that the increment of money supply could
follow the flow and also in conformable with the development of the country which
need a strict discipline towards the monetary authorities and government. The lack
of capital, and the limit of government income are usually triggered the government
to borrow money from Central bank extravagantly. If this keep happening, it will
speed up the money supply and consequently make the money stock increase than
what it’s needs. Second, Central bank need to be more careful in supervising the
improvement of foreign exchange especially with the import and export activities.
Because of its instability the central bank needs to be more careful in order to
prevent the economic growth to be denying.

By improving the accuracy of monetary policy towards the expenditures in

domestic also in foreign trade, it will affect the money spread to be more
manageable and stable. And eventually supported the government to balance its
expenditures which is known through the fiscal policy.

Monetary Policy Indicators

Essentially cash stock and loan costs are highlighted famously as operational target
and furthermore as a marker to evaluate financial arrangement position. A marker
is characterized as some factor, which is affected by financial approach and gives
early data on the possible results for the last factor. A decent marker or on the other
hand data variable gives driving or contemporaneous data on the expected
developments in strategy goals and it is ordinarily not treated as an article to be
constrained by national banks (Freedman, 1995).
In the 1960s and 1970s, money stock was highlighted as the most common example
of monetary policy indicator. It is also concerned by the monetarist as the best
indicator to indicate a good monetary policy. Furthermore, it had also been proven
by the monetarists such as by Friedman and Shwartz (1963) investigated how
exactly the respond of money stock towards the circumstances of the US economic.
they find out that the stock of money does have a significant role in determining
monetary policy stance in US economy. Another study had also concluded in the
same way, that had proved to how capable of money to effect the real output, this
study was also concluded by the Monetarists, Sims (1972). A lot of monetarists
have stated that a policy maker could gain significant data’s from money, which
those data’s could help the policy maker to investigate how effective is the indicator
to reduce the ambiguity and issues that might be faced by the policy maker itself and
the market participants. The monetary policy indicator variables' information
content is extremely valuable, especially to policymakers. Variables with a high
information content could be used as the important variable in macroeconomic
policy execution.

Nevertheless, those statements do not seem to be entirely right. Nelson (2002) and
Nelson (2003) consider that money might potentially be insignificant to become the
indicator of monetary policy stance. On one hand, the data’s from the money stock
might helpful to the policymaker to determine the monetary policy. But on the other
hand, it’s still depending on the stability of the money demand. This conclusion has
triggered a lot of researchers to find the alternative monetary policy indicato rs.

In the Keynesian framework, it gives a stress on the interest rate. Through this
interest rate the policymaker could determine when the exact time to tighten or
loosen the monetary policy. As it proved by Bernanke and Blinder (1992) by
implementing the three-month Treasury bill rate, a ten-year government bond rate
and a federal (fed) fund rates on different economic activities. A result can be found
by this study through VAR methodology which proved that beside the money stock,
a policymaker can also utilize the fed funds because its significant information can
be useful to built monetary policy in US. On the other hand Friedman and Kuttner
(1992) has shown through their result study which stated monetary policy stance
can be investigated through spreading the commercial treasury bill. Apparently,
they discovered that the wider spread indicated monetary tightening which leads to
a decrease in business spending and subsequently real economic activity.

However, other researchers Bernanke and Mihov (1998) has also stated that it is not
necessary to indicate which is the best indicators for determining the monetary
policy, it is because price (inflation) can possibly have two or more factors. 4
different indicators such as M1, the term spread, the overnight rate and the exchange
rate had been tested by Fung and Yuan (2010) by using the Bernanke and Mihov
methodology which has proved that there is one indicator that considered to be the
significant ones, namely the over-night policy rate.

Furthermore, the researchers (freedman, 1995; Nadal De Simone; Hataisaree, 1998

and de Wet, 2002) are also stated that a better indication of an overall policy stance
may be served by Monetary Conditions Index (MCI) through combining of multiple
monetary policy indicators such as by combining both exchange and interest rates
in a single monetary policy indicator. A better analysis of overall monetary
conditions may be achieved by the monetary authorities if it is supported by the
utilization of the MCI including the combination between interest and exchange
rates. Therefore, the assessment of the monetary policy effectiveness may be
analysed by using MCI. It was proven by many central banks in industrialised
countries such as the Reserve Bank of New Zealand, the Central Banks of Norway,
Sweden, and Switzerland.

Canada and the Reserve Bank of New Zealand may has successfully implementing
the MCI in the first half of the 1990s. however, in the second half of the 1990s those
countries were starting to face a condition where its economy condition moved in
an unintended ways because its Monetary conditions (Mayes and Riches, 1996).
Similarly, the MCI implementation in Swedish and Norwegian central banks in
determining the monetary policy. It doesn’t seem to be showing any significant
effect to its monetary condition.

The Alternative Monetary Policy Indicator Using Future Information

A gap between GDP growth and official interest rates in some big economies such
as China, India, Japan, Canada, and the Euro area had shown in the research by the
Economist (2007). It concluded that the nominal GDP and interest rate have no
differences on its movement pattern which means that nominal GDP behave
similarly to interest rate and potentially significant to indicate the monetary policy
stance. Furthermore, it was also motivating the Islamic Monetary system to find an
alternative monetary policy indicator.

Researchers who are in resemblance with the Economist (2007) such as

Hanif and Shaikh (2010) has stated that in the years between 1970 -2008 nominal
GDP growth and the official interest rate had moved along in average based on
available data for Canada, 16 major Euro countries, the US, Japan, and the UK.
Noreha and Radziah (2012), Hanif and Shaikh (2010) were encouraging the
adoption of nominal GDP growth as the indicator of monetary policy in the case of
Malaysia. Not just as a variable to gain information for the banking sector but it
could also support the monetary policy to be acceptable by both conventional an
Islamic financial system in central banks. Economist (2007) Hanif and Shaikh
(2010) and Noreha and Radziah (2012) agreed in their research that th e nominal
growth of GDP is not simply be utilized as monetary policy indicator. But it is also
more comprehensive and reflects the real sector. On one hand, in the asset side the
nominal growth of GDP do works as a monetary policy indicator for Islamic finance
product. On the other hand in the side of liabilities, products can be priced upon the
difference between nominal growth rate and the cost of deposit mobilization (Hanif
and Shaikh, 2010).
2.2 PREVIOUS STUDIES.
1st Study – Zuriyati Ahmad and Abdul Ghafar Ismail.

This study was conducted in 2018 with the title of “ALTERNATIVE OF

MONETARY POLICY INDICATOR: PANEL DATA ANALYSIS FROM
ISLAMIC BANKS IN MALAYSIA”

the objective of this study is to investigate the future growth of nominal GDP as an
alternative variable for monetary policy indicator in Islamic monetary system.

The investigation will utilize some data provided by 17 Islamic Banks in Malaysia
which implement full fledge or Islamic windows scheme spanning from 2005 to
2010.

The investigation was conducted through using GMM system.

The result of this study had concluded that of all the traditional variables of
monetary policy indicator such as interest rate, money stock, even the Monetary
Condition Index doesn’t seem to be showing any significance as the monetary
policy indicator in Malaysia. Nevertheless, because of its ability to affect the bank
financing also the ability to forecast the performance of economy in the future. This
research concluded that the nominal growth of GDP is potentially significance to
be the monetary policy indicator.

2nd Study – Muhammad Nadim Hanif and Salman Ahmed Shaikh

This research was conducted in 2009 with the title of “Central Banking and
Monetary Management in Islamic Financial Environment.”

This paper intends to prove that nominal GDP growth rate is equivalence with the
official interest rate for ‘advanced,’ ‘all,’ and some Muslim Countries.

The conclusion of the research is that the necessity of an Islamic country especially
towards the monetary system is not necessarily just to find an acceptable benchmark
for Islamic financial instruments but it was also to look into policy regime under
which central bank are operating. Therefore, it shown that nominal growth of GDP
is acceptable by both conventional and sharia system, even for the conventional it
moves almost together with the conventional official policy rate. and the sharia
system is essentially based on actual economic activity. Both still potentially
implements the same indicator. As it has proven by a lot of countries, nominal
growth of GDP can be utilized as benchmark for the price of loans to/from the rest
of the world including bilateral/multilateral and institutional arrangements. An
issue that might be face by countries in external debt management under Islamic
finance principles can be solved by pricing the international management financial
transactions. Furthermore, this study also recommends the central bank to utilize
the nominal income targeting.

3rd Study – Noreha Halid and Radziah Abdul Latiff

This study was conducted in 2012 with the title of “Developing reference rate of
return based on real sector economy: A case of Malaysia.”

The purpose of this study is to represent a real sector of the economy through
utilizing nominal GDP growth rate as an alternative measure of reference rate for
Malaysia.

CHAPTER 3

METHODOLOGY

3.1 DATA SOURCES.

This investigation will utilize secondary data as the data sample was taken from 12
sharia banks in the population of Indonesia which implement full fledge or Islamic
windows scheme spanning from 2016-2021.

3.2 DATA ANALYSIS METHOD.

In order to validate the appropriateness of the alternative monetary policy indicator

this study will use GMM system method. There 2 reasons why this study use this
method. In the first place, the investigation works with a yearly informational index
and subsequently including additional delays appears to be not suitable from a
monetary perspective on change in the financial area and second to improve
determinations from a measurable perspective in choosing the most the powerful
model.
3.3 MODEL SPECIFICATION.

Fit = β0 + β1 GDP + β2 D + β3 MP + εt

As can be seen through this model above, it is shown that the amount of financing
in individual banks in period t is symbolized as Fit which this variable is depending
on some other variables such as gross domestic product (GDP), the available
amount of deposits (D) and the monetary policy indicators (MP).

Because of its direct measure in reflecting the economic performance, GDP is taken
as a dependent variable. Economic conditions play a major role in determining
Islamic bank financing in Indonesia. Essentially, in order to earn a good return at
the end of the day borrowers can expect their ability in paying back loans through
a stable GDP so that they can predict the economic performance and what is best
for their investment projects. Because of its enormous interconnection and closer
connection with investment it has encourage the ability of Islamic bank to adapt
bank financing behaviour in reacting to signals from GDP. Controlling the business
cycles and demand side effects is also become the reason why it is necessary to
include GDP in this model.

In reacting to the signals of GDP factors, Islamic banks can possibly rearrange its
financing behaviour. For example, if it is showing a positive signal then the Islamic
banks would be more working on financing and vice versa. Like when the periods
of boom the bank might offering more loans at that time, and restrain lending when
the economy is in recession.

The willingness of Islamic bank to supply financing is also affected by the deposits
in each bank. It is because of its availability of enormous source for bank financing.
Namely that bank will merely depending on deposits as a source of funds which
lead to more financing supply sensitivity to monetary policy changes. Any additions
or subtractions of deposits may influence future financing activities.
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