ANALYSIS OF THE RELATIONSHIP BETWEEN FINANCIAL SECTOR

DYNAMICS, INFLATION AND ECONOMIC GROWTH

Josua Pardede
Bank Internasional Indonesia, JPardede@bankbii.com

Abstract - This paper aims to analyze interrelationship

between financial sector, inflation and economic growth in
Indonesia. Vector Error Correction Model (VECM) is
employed in this analysis. Empirical results indicates that, in
long run, there is positive relationship between financial
deepening and economic growth while implied risk premium
has a negative effect on economic growth. Moreover, there is
negative relationship between implied risk premium and
inflation while exchange rate depreciation has a positive
effect on inflation.

Keywords: - Economic growth, financial deepening, inflation,

Vector Error Correction Model
I. INTRODUCTION
Financial system possesses a very significant role in supporting
the growth of nations economy. This is due to the capability of
financial sector to gather some funds from the bank liabilities
outstanding and transfer the fund as a funding resource and
investment. This will further stimulate investment and accelerate
economic growth. On the other hand, an efficient financial sector
should be able to minimize asymmetric information, indicated by
high transaction cost and information cost occurring in financial
market (Levine, 1997; Fritzer, 2004 and Kularatne 2002).
The term of financial deepening is commonly used to illustrate a
rapid development of financial institutions such as banks, capital
markets and insurance companies relative to the size and
magnitude of the nations economy. This is indicated by
penetration of several financial products and services throughout
all economic sectors to fulfill financial needs. In other words,
financial deepening is an increased in provision of financial
service geared to fulfill financial needs in all levels of society,
followed by enhancement of market volume. It is expected that
the increase in financial market volume generated from the

financial sector is able to absorb volatility from each market

participant.
According to several economists, the fundamental of financial
deepening is the development of financial sector that supports
economic growth through either a supply leading or a demandfollowing (Levine, 1997; Liu, 2003; Lynch, 1996; Kiyotaki and
Moore, 2005; Mohan, 2006). An efficiently functioning financial
system will support and enable productive fund allocation and
mitigate the impact of asymmetric information and transaction
costs. The efficient financial system is indicated by proper
portfolio management and risk management which enhance
financial system resistance towards market shocks.
Worries on the risks and dilemmas due to financial deepening
exist in policy development process in maintaining
macroeconomic stability both directly and indirectly. The direct
impact of financial deepening is related to the vulnerability of
domestic economy towards sudden capital outflow. Any
negative changes in investors risk appetite results in financial
instability, retarding a sustainable economic growth. On the
other hand, the indirect impact of financial deepening arises
when the increasing access to financial sector pushes domestic
demands, which are unsupported by the economic capacity. With
regard to this matter, overheating economy will occur due to
excessive domestic liquidity, causing inflation expectation which
leads to macroeconomic instability. The latter impact makes
sense to occur. With pro-cyclical funding characteristics, the
loan provision will be less prudent during the booming period,
impacting the financial system. This impact, however, usually
start to appear in recession. Loose requirement of loan provision
causes pressures on macroeconomic and financial stability.
Monetary stability, financial system stability and economic
growth are three dimensions that are interrelated. According to
the premise of monetary stability and financial stability mutually
supportive, the attainment of stabilities in both sectors
encourages long-term economic growth. Conversely, economic
growth which is in line with the growth of production capacity

can improve monetary stability and financial stability. If this

process is maintained, sustainable economic growth will be
achieved in the long-run.

Hypotheses, proposed conclusion which needs to be tested for its

validity, of this research are the following: first, there is a
positive relation between financial deepening and economic
growth and negative relation between financial system stability
and economic growth. Second, financial system stability is
negatively related to monetary stability (inflation), while
exchange rate depreciation is positively related to inflation. In
order to further understand the formulated problems and the
purposes of this research, a research framework is constructed as
follows:

Figure 1.1 The relationship between monetary stability, financial

system and economic growth
Several studies discuss basic theories on the relationship
between financial sector development and growth such as studies
done by Schumpeter, McKinnon (1973), and Shaw (1973). The
main implication of McKinnon-Shaw research is that the
restriction on banking system (such as by imposing the ceiling
on bank interest rate, high reserve requirements and credit
program) will retard financial system development which will
then reduce growth rate. Similar conclusion is asserted by recent
studies on endogenous growth theory which summarizes that the
long-term economic development depends on the advancement
of the financial sector. Vast empirical studies on the relationship
between financial sector development and economic were done
by Levine 1997. Another study was done by King and Levine
(1993b), which concludes a strong positive relation between
financial sector development and output rate. Other than that,
King and Levine (1993b) also state that the development of
financial sector can predict future economic growth. This finding
further confirms that financial sector development influences the
economic growth.
On the other hand, however, financial sector development
potentially elevates the price level (inflation). Further
observation indicates that high inflation will disrupt financial
institution operations and financial market in a country. As an
illustration, a high inflation rate will directly related to price
uncertainty, interest rate and currency and in turn will increase
cost to mitigate potential risk. Inflation will also promote
currency devaluation and vulnerability towards speculative
action, such that hedging instrument will become more costly.
The impact of high inflation rate will restrain trading process and
foreign capital inflow.
Further, the main problem formulated which is the focus of this
research is What are the relationships between financial system
dynamics, inflation and economic growth? Based on the
problem statement above, the purpose of this research is, first, to
analyze the relationship between financial system, inflation and
economic growth. Second, to analyze efforts made to improve
financial system stability to promote economic growth and
maintain price stability.

FIGURE 1.2 Research framework

II. LITERATURE REVIEWS

II.1Financial Deepening
Schumpeter (1911) argues that services provided by
intermediaries function of financial system such as mobilizing
savings, evaluating projects, managing risks, monitoring
managers and facilitating transactions play vital role in fostering
technological innovation and economic growth (Levine, 1993).
In line with Schumpeter, Levine (1995) further divides financial
sector into five service categories based on the function of
financial sector in supporting economic growth. The
development of financial sector/financial deepening can improve
quality and its function in economy in terms of:
1.
2.
3.
4.
5.

Providing information about potential investment

opportunities;
Monitoring investment and exerting corporate
governance;
Trading, diversifying and managing risk;
Mobilizing and pooling of savings;
Facilitating the exchange of goods and services.

Each of these functions can influence savings rate, investment

decisions and hence influence economic growth.
Evaluating a firm and market condition in order to acquire
information for future investment plan involves high costs.
However, this must be accomplished because capital owner or

potential investors will not want to invest their money into

production activities with limited reliable information. High
information cost and transaction cost create less optimal
investment value (Levine, 2005).
The intermediary function of financial sector reduces cost of
transaction and cost to acquire information about a company and
market condition, hence lowering the cost to potential investors
when compared to doing it themselves. Through the
development of effective financial system, financial intermediary
can provide information on the most promising and most
profitable companies to invest in; therefore resource allocation
can be done efficiently which then accelerates the economic
growth (Levine, 2005).

financial system not only depends on individual financial

institutions, but also depends on complex interactions between
financial institutions, the real sector and the financial market.
The difference between financial stability and monetary stability
refers to price stability in general. According to Croket, financial
instability will have a negative impact on the effectiveness of
monetary policy (monetary stability) if banks cannot transmit
their monetary policy properly. Theoretically, in a closed
economy system, monetary policy strongly links to financial
stability. This is because in closed economy system, there is a
lack of externalities that can affect domestic monetary policy.
Therefore, the effect of monetary policy on domestic financial
stability becomes very dominant.

The financial systems ability to provide risk diversification can

affect long-run economic growth by altering resource allocation
and the savings rate. Capital owner usually dislike risk, while
projects offering high profitability normally have greater risk
than that with low profitability. The ability of financial system to
diversify risk can offer higher profit at lower risk to capital
owner to invest in high-risk projects, hence creating positive
impact on the economic growth (Levine, 2005).

Conversely, in an open economy, the relationship between

monetary policy and financial stability is more tenuous. This is
due to external disruptions in the domestic economy, hence
requiring supporting policies, namely fiscal policy, in order to
minimize the loose relationship between monetary policy and
financial system stability.

Pooling may also occur through financial intermediaries, where

investors (a party who provides funding) entrust their wealth to a
certain financial institution that invest in firms (a party who
requires funding). Financial system which is more effective at
mobilizing and pooling the savings of individuals can
profoundly affect the economy by increasing savings and capital
accumulation (Levine, 2005).

II.3 The Relationship between Inflation and Economic

Growth

According to Mishkin (2004), one of the monetary policy

transmission mechanisms is through financial sector credit
channel. Financial sector credit channel is based on the role of
banks in corresponding financial system to anticipate
asymmetric information issues occurring in credit market.
Asymmetric information issue refers to information gap related
to fund provision and loan provision, resulting in the inability to
efficiently provide credit to the party in needs. The monetary
policy transmission mechanism through financial sector credit
channel is as follows:

In recent decades, relationship between inflation and economic

growth has attracted economists, policy makers and central bank
attentions both in developed and developing countries.
Specifically, the main concern is whether inflation is required for
economic growth or contrary, whether inflation is dangerous to
the nation's economy. Basically both ideas create intense debates
theoretically and empirically. This issue was first developed
from a controversial idea between structuralists and monetarists.
Mundell (1965) and Tobin (1965) predict positive relationship
between inflation rate and capital accumulation rate, which in
turn, implies positive relationship towards economic growth.
They argue that since money and capital are substitutable, an
increase in the rate of inflation increases capital accumulation by
shifting portfolio composition from money to capital and
thereby, encouraging the rate of economic growth (Gregorio,
1996).

M bank deposits bank loans I Y

Monetary policy increases societys deposit in financial sector,
which increases availability of credit. Borrowers rely on credit
provided by financial sector to finance their business activities;
hence the increase in credits will increase investment and
increase output.
II.2

Financial System Stability

Sutton and Tosovsky (2007) describe financial stability as a

condition where financial system is able to: (i) allocate resource
efficiently into productive activities at different times; (ii)
predict and measure financial risks, and (iii) absorb shocks or
sudden/dramatic changes in economic conditions. Financial
system stability includes efficiency and resilience of the
financial system, which is a complex concept. Stability of the

Until now, although the relationship between inflation and

economic growth remains controversial, several empirical
studies show both negative and positive relationship between the
two macroeconomic variables. Some economists agree that low
and stable inflation stimulate economic growth and vice versa
(Mubarik, 2005). A question might arise on how low is the
intended inflation rate. The answer clearly depends on the nature
and the structure of economy which varies in each country.
Macroeconomic experts have adopted econometric techniques
by only looking at non-linear effect which concludes that the
impact of inflation on economic growth may be positive up to a
certain threshold, after which the contribution becomes negative
(Sweidan, 2004). This supports structuralists and monetarists
advanced arguments, by suggesting that low levels of inflation
may initially be supportive of growth gains, but once the
economy achieves faster growth inflation can be detrimental
towards economic growth.

II.4 The Relationship between Financial Deepening and

Economic Growth
Patrick (1966) identifies two possible causal relationships
between financial deepening/financial development and
economic growth. The first relationship is demand-following
view that postulates demand in every financial service is affected
by economic development; hence the creation of a modern
financial sector is a response of demand in the economy (savers
and investors). In this demand leading relationship, the faster the
economic grow, the larger is the demand for financial
intermediary service, transferring savings from a slow growth to
a high growth sector (Kar and Pentecost, 2000:5). The second
relationship is the supply leading. According to the supply
leading relationship, the existence of financial sector and its
services will increase investment and economic growth.
Greenword and Jovanovic (1990) argues that there is a two-way
relationship between financial development and economic
growth. On the one hand, economic growth stimulates financial
development. This occurs because financial institution
establishment requires a fixed cost payment. The cost, which is a
fraction of income, will decrease in growing economy. On the
other, by collecting and analyzing information from many
potential investors, financial institutions can undertake
investment projects efficiently and, hence, stimulates investment
and economic growth.
Diamond (1984) links financial sector in economic growth
through its role in minimizing monitoring costs emerged from
incentive issues between fund owner and investors. The
incentive matter arises due to asymmetric information occurring
between owners and investors, hence, causing moral hazard and
adverse selection. With low monitoring cost, intermediation in
financial sector supports improvement of social welfare.
Recent research on the interaction between financial
development and economic growth by King and Levine (1993)
summarizes that financial development determines economic
growth. Conversely, Arestis and Demetriades (1997), Shan and
Morris (2002) and Shan, Sun and Morris (2001) assert that the
above hypothesis only valid in several countries surveyed, hence
there is no general conclusion can be made.
Positive view on the financial system hypothesis which
stimulates economic growth usually focuses on the role of
financial development in mobilizing domestic savings and
investment through open and liberal financial system, in
enhancing productivity through efficient financial market
creation. Chen (2002) argues that central bank independency in
interest rate policy development and financial intermediation can
result in sustainable economic growth.
II.5 The Relationship between Financial Deepening and
Inflation
Boyd, Levine, and Smith (2000) model variables of bank credit
extension to the private sectors, volume of bank liabilities
outstanding, stock market capitalization and trading volume (all
as ratio to Growth Domestic Product/ GDP) and inflation. They
find that at low-to-moderate rate of inflation, any increase in the

rate of inflation markedly reduces volume of bank lending to the

private sector, lowers the level of bank liabilities outstanding,
and significantly decreases level of stock market capitalization
and trading volume. They also assert that the relationship
between inflation and financial market development becomes
flatter/unclear. This is because the increase in the rate of
inflation has a much greater effect on financial development at
low inflation rate than at high inflation rate.
To further illustrate, a high level of inflation is related to
reduction in rate of return of several assets. The high inflation
rate also creates credit restriction, reduction in financial
performance and lowered real sector activities. Why does high
level of inflation causes reducing in long-term rate of return?
The answer is because high money demand in an economy
promotes inflation. As an example, banks in high inflation
economy provides fund or capital reserve in large amount.
Previously known, high inflation rate acts like a tax on bank
reserves. When this tax is paid by the clients, then high inflation
rate reduces deposit interest rate. Further, due to competition
between bank deposit and other assets, lowering in deposit
interest rate will also result in reduction of return on other assets.
Barnes, Boyd and Smith (1999) and Boyd, Levine and Smith
(2000) highlight that the abovementioned condition is valid in a
nations economy with high rate of inflation, and high rate of
inflation is related to low return on short-term asset, government
obligation and good quality loans.
II.6

Monetary Stability and Financial System Stability

Before looking at the relationship between monetary stability,

financial system stability and economic growth, it is essential to
agree on definitions related to monetary stability and financial
stability. The accepted definition of monetary stability in the
context of subdued inflation in academics and for the central
bank is a condition that guarantees the achievement of price
stability, as defined by low and stable prices (inflation). Price
stability held a very important role in a nations economy
because price changes highly influence the process of adjustment
and decision making by economic agents. However, an
understanding of financial system stability has not yet been
concluded due to the absence of agreement on a definition.
Miskhin (1991) defines financial stability as a condition in which
financial sector guarantees efficient allocation of savings and
investment in sustainable manner and without any significant
disturbance. A more commonly used definition in analysis is that
monetary stability is a situation marked by stable asset price,
without banking crisis, with market interest forces that is easily
transmitted into interest rates. (Issing, 2003).
The definitions given above also generate another question in the
relationship between monetary stability and financial system
stability. Are the two mutually supportive or even negatively
correlated in the sense of trade-off? The conventional view
states that monetary stability supports financial stability. The
main proponents of this view regard monetary stability or price
stability as a sufficient condition for financial stability
(Schwartz, 1995). This view assumes that price stability or
inflation is one of the main factors behind financial market
instability. A related idea is that inflation is regarded to increase
the probability of misperceptions concerning future income
attainment and worsens asymmetric information between lenders

and borrowers. In another point of view, a high inflation also

promotes large price fluctuations, which create uncertainties in
business. This argument is supported by empirical evidence
showing that financial crisis and banking crisis were generally
caused by sharp increase in price level (Bordo et al, 2000;
Calomiris and Gorton, 1991).
This argument is consistent with the idea that banking crisis will
trigger monetary instability In this respect, a twin crises which
involves banking system and the exchange rate will result in an
unexpected monetary policy (Goldfajn and Gupta, 2002). In
exchange rate crises, a tight monetary policy has the potential to
stabilize the exchange rate and the financial sector. However, in
banking crises, the reverse will apply. In situation like this, the
selection of monetary policy response will be influenced by
several factors, such as the extent of currency mismatch in
domestic banks and the discretion of central bank policy in
providing liquidity in a crisis situation (Shin, 2005). Thus, with
regard to the conventional point of view, generally there is no
trade off between monetary stability and financial stability.
The new environment hypothesis, however, states that there is a
tradeoff between monetary stability and financial stability. This
is based on the proposition that inflation control by the central
bank can improve markets positive perception on the economy.
Borio et al. (2001) indicates that the combination of asset price
increase, high economic growth and low inflation can foster
overoptimistic market on economic performance. This will
escalate asset and credit market activities that exceed the
potential production capacity which in turn will promote asset
price increase and inflationary pressure.
Issing (2003) studies the trade-off identification based on time
horizon. In this respect, trade-off may occur in short-term, that is
during the period of rapid disinflation (inflation below the
targeted rate). In the new environment', this may bring on
fragility to crises due to reduction of nominal interest rates,
which further exacerbates moral hazard in the credit market. In
several cases, the very low inflationary can trigger asset price
bubble. The fragility to crises will tend to be short-lived because
the central bank as monetary authority will raise the nominal
interest rates to settle down inflation as a result of asset price
increase and prevent long-term inflationary pressure.
Therefore, in the context of central banks forward looking
policy and in relation to price stability, the problem of trade-off
would slowly diminish. From other point of view, regarding
threats arising from financial system instability towards medium
and long-term monetary stability, central bank policy should
consider financial stability in maintaining price stability.
Implication of conflicts in short-term may not set aside a
conventional policy that price stability supports financial system
stability

III.RESEARCH METHODOLOGY
III.1 Research
Specification

Variable

Identification

and

Model

III.1.1 Research Variables

Research variables used in this research are: economic growth
(GROWTH), inflation (INFLATION), creditto-GDP ratio
(FINDEV), interest spread (SPREAD) and exchange rate
depreciation of US dollar to rupiah (XRATE).
The variables are defined as follows:
a)

GROWTH represents Indonesian economic growth,

which is nominal GDP at the current price level in
billion rupiahs. The use of nominal NDP as an
economic growth indicator has been used by King and
Levine (1993), Khan and Senhadji (2000), Rousseau
and Wachterl (1998) and Aziakpono (2003). The data
being used is quarterly nominal GDP interpolated to
monthly data using Quadratic-match sum technique.
After interpolation, the monthly data is annualized. This
is obtained from the addition of previous year nominal
GDP to current GDP. As an example, annualized
nominal GDP in April 2010 equals to the addition of
nominal GDP March 2009 up to nominal GDP April
2010.
b) Inflation, which is percentage of change in Consumer
Price Index, is a proxy of monetary stability variable.
c) Credit-to-GDP ratio is the ratio between nominal credit
to nominal GDP. The larger the bank credit extension to
the private sectors, the larger the investment which
means that the greater economic growth. Credit growth
is therefore proportional to economic growth. Funding
ratio is an important indicator of financial sector in
transferring fund from savers (with excess fund) to
investors in need. Credit-to-GDP ratio is used as a
variable in financial development.
d) Interest Spread as proxy Implied Risk Premium is the
difference between interest rate provided by banks and
interest rate set by monetary policy, the 1-month SBI
rate. The use of interest spread is one of financial
system stability variables.
e) Exchange rate depreciation is the level of exchange rate
depreciation of US dollar to rupiah. Appreciation
(increase in exchange rate) supports economic growth.
In other words, the exchange rate depreciation is
directly related to economic growth. Exchange rate
depreciation is used as external factor variable.
III.1.2 Data
This research utilizes time-series data between 2002:1-2010:12
time period. The data are collected from several resources, such
as Indonesian Economic and Financial Statistics (SEKI), Bank
Indonesia, International Financial Statistics (IFS on-line),
International Monetary Fund (IMF) and Financial Structure
Database, World Bank.

III.1.3 Model Specification

III.3

Generally, the VAR model used is as follows:

Johansens cointegration test is based on the VAR(p) model of

non-stationary variables. For simpler Johansen test procedure,
VAR(1) model will be used. Remember that VAR (1) model is
noted in matrix notation:

XRATEt

+ XRATE
=

SPREADt

+ XRATE
=

FINDEVt

+ XRATE
=

v 1 =
v 1
=

v 1
=

+ 22 v SPREADt v + 23v FINDEVt v + 24 vGROWTH t v + 25v INFLATION t v + 2t

t v
2
21v
v 1=
v 1
=
p

v=
1
v 1=
v 1
=

+ 32 v SPREADt v + 33v FINDEVt v + 34 vGROWTH t v + 35v INFLATION t v + 3t

t v
3
31v
v 1=
v 1
=
p

+ XRATE
=

GROWTH t

+ 12 v SPREADt v + 13v FINDEVt v + 14 vGROWTH t v + 15v INFLATION t v + 1t

t v
1
11v
v 1=
v 1
=

Cointegration Test

v 1 =
v 1
=

SPREAD

+ FINDEV

Yt =
1Yt 1 + t

+ 44 v GROWTH t v + 45v INFLATION t v + 4t

t v
t v
t v
4
41v
42 v
43 v
v 1=
v 1=
v 1=
v 1
=
p

v 1
=

v 1
=

INFLATION t =
5 + 51v XRATEt v + 52 v SPREADt v + 53v FINDEVt v + 54 vGROWTH t v + 55v INFLATION t v + 5t
v 1=
v 1
=

v 1 =
v 1
=

v 1
=

While the model VECM specification (restricted VAR) is as

follows:
yt = yt 1 + 1yt 1 + ... + p 1yt p +1 + ut
XRATEt

SPREADt
yt = FINDEVt ; i = ( Ai +1 + ... + Ap ) , i = 1,..., p 1; = ( I 5 A1 ... Ap )

GROWTH t
INFLATION
t

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 reparameterization 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:

III.2 Bivariate VAR system with order p

Yt = 1Yt 1 + t

VAR with order p of bivariate system or two variables

y
yt = 1t can be defined as
y2 t

where:
Y = Yt Yt 1 and = 1 I 2

y t = + 1 y t 1 + ... + p y t p + t

This VECM (1) form contains information about short-run and

long-run changes stated by parameter i and . This Matrix

where
=

is two-dimension vector,
=
, i
=

11 , i

12 , i

21 , i

( 2 2)

coefficient matrix

and

1, 2, ..., p

is

22 , i

= 1t
2t

is a white noise

For instance, a component of vector Yt is a first order

integration or written as I(1), then Yt-1 is a linear combination
of variable Yt-1 I(1). In order to estimate all combination
possibilities from Yt-1 which results in close correlation with
matrix
Yt-1, a stationary element, Johansen uses
characteristics as follows:

vector. In other words:

1) t has zero mean, E [ t ] = 0
2)

3)

t and s

has constant variance, E t ' = , t

t
are not correlated, for

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.

t s.

Equation y t = + 1 y t 1 + ... + p y t p + t can be written

1.
2.

as follows:

y
y =
+
1t

11 ,1

2t

21 ,1

12 ,1

22 ,1

y
+
y
1 t 1

11 , 2

2 t 1

21 , 2

12 , 2

22 , 2

y
... +
y
1t 2

11 , p

2t2

21 , p

12 , p

22 , p

y
+
y
1t p

1t

2t p

2t

Two-dimension random vector ..., y t 1 , y t , y t +1 ,... is a stochastic

process vector. A stochastic process vector is stationary if:
1) E [ y=
] , t
t
2) cov( yt , yt - h ) =
E [( yt )( yt - h ) '] =
y ( h), t dan h =
0,1,2,...

3.

If Rank()=0, then, there is no cointegration

between variables
If Rank()=m (m : the number of variables in
VAR model), then all variables are cointegrated
If 0 < Rank() <m, then Rank () states the
number of variables that are cointegrated between
0 and m.

Matrix can be decomposed to = Twhere is speed of

adjutsment and is long-run coefficient matrix so that TYt-1 up
to m-1 combinations is a cointegrated relationship which
ensures that Yt reaches long-run equilibrium. Further, Rank
(T) can be determined by calculating eigenvalue from T.

III.4 Innovation Accounting

Basically the test is employed to test the dynamic structure of the
system variables in the model which have been observed, as
reflected by the variables of innovation. In other words, this test
is a test of the variables of innovation. This test consists of:
a) The Impulse Response
This test is used to observe the effects of a standard deviation
shock to one of the variable of innovation on the current
values and the future value of endogenous variables included
in the model
.
b) The Cholesky Decomposition
The Cholesky Decomposition commonly known as variance
decomposition provides information about the relative
importance of each variable in the VAR system according to
the shocks. This test is basically another method to describe
the dynamic system contained in VAR by collecting
estimates of error variance of a variable or, the difference
amount between the variance before and after the shock.
Both shocks are originated from that variable itself and from
other variables.

will result in an elevation of private sector credit. Furthermore,

increase in investment credit would in turn promote economic
growth.
According to long-term regression equation, credit-to-GDP ratio
significantly influences economic growth. Meanwhile, in shortterm equation, credit-to-GDP ratio variable shows insignificant
influence. This is in line with findings of Dornbusch, Fischer and
Starz which state that investment affects long-term economy
(2001:335).
Shown below are the growth of credit-to- nominal GDP ratio and
the growth of nominal GDP between 2002 and 2010.

IV. DATA ANALYSIS

IV.1 Descriptive Analysis

Figure 4.2 Credit-to-GDP ratio and economic growth

Illustrated below is credit growth and nominal GDP during the

observational period, from 2002 to 2010.

Figure 4.2 above shows that there is a positive relationship

between financial deepening and economic growth. The upward
trend of credit-to-GDP ratio observed between 2002 and 2005, is
followed by rising economic growth. At the end of 2005 and
during 2006, the credit-to-GDP ratio declined and fund
placement at Bank Indonesia rose. This phenomenon is related to
Indonesias economic turmoil occurring at that time. In late
2005, government policy in reducing fuel subsidies resulted in
negative pressure on the national economy.

Figure 4.1 Credit growth and economic growth

Figure 4.1 depicts that at the beginning of 2003, the credit

growth is higher than the economic growth. This situation lasts
up to early 2006 where bank lending significantly declined and
credit growth attained its lowest level at the third quarter of
2006. This differs from the nominal GDP growth that
experiences high growth. From the figure above, in general,
credit growth and economic growth is positively related although
a lag exists, where the credit growth tends to precede the output
growth.
Availability of bank lending is highly influenced by bank
liabilities outstanding. Transmission mechanism channel for
credit channel provides the idea that an increase in money supply

In early 2006, amid of unrecovered investment climate

perception and economic slow down, credit demand and supply
tended to drop and bank operation was more focused in shortterm financing, especially in consumer sector and money market
placement. Observing obstacles posed by banks, during 2006,
Bank Indonesia took several steps to give more room to banks in
performing its intermediary role, upholding prudential aspects.
All policies developed were placed within an integrated and
systematic framework through January Policy Package (Pakjan)
2006 and October Policy Package (Pakto) 2006. One important
decision made in strengthening banking structure for economic
improvement is adjustment of definition in Credit Provision
Maximum Limit (BMPK) setting.
The global economic condition with enduring pressure from the
crisis created several major challenges during 2009. The
challenges were quite surfaced at the beginning of 2009, as an
impact of global economic crisis which peaked in the fourth
quarter of 2008. Uncertainties related with how deep the global
contraction and how quick the global economic recovery will
take place, not only increased risk in financial sector, but also

negatively impacted economic activity in the domestic real

sector. The condition created pressure on monetary stability and
financial system stability on the first quarter of 2009, while
economic growth remained in its down trend due to a deep
export contraction of goods and services.
40
35
30
25
20
15
10
5
2003

2004

2005

2006

2007

CREDIT GROWTH

2008

2009

2010

GDP GROWTH

Figure 4.3 Credit growth and economic growth

Figure 4.3 shows the relationship between credit growth and
economic growth. It is evident that between 2002 and 2005, the
rise in economic growth was followed by positive credit growth.
While in the post global crisis, between 2008 and 2009, the
pressure on output/ the slowing down of economic growth was
followed by the reduction in credit volume distributed. This
indicates that the inherent issue embedded in short term capital
flow is the 'procyclicality', where massive capital inflow occurs
in economic boom and capital outflow occurring in economic
slowdown.
In a rapidly growing economy, capital inflow may cause 'internal
imbalances' because capital flow also triggers inflationary
pressures and asset bubbles, and in turn promotes external
imbalance. This is because the appreciation pressure resulted
from capital inflow exacerbates the current account. Conversely,
in an economic slowdown, a sudden reversal of capital flows can
trigger depreciation pressure and macroeconomic and financial
system instability.

Figure 4.4 Lending rate, 1-month SBI rate and interest spread
Figure 4.4 indicates that the lending rate quickly responses the
rise in SBI rate. In situation where SBI rate loosens, the lending
rate shows a lagging response. This condition is clearly seen in
the fourth quarter of 2005 to the first quarter of 2006 and in the
first quarter of 2009. In the fourth quarter of 2005 to the first
quarter of 2006, Bank Indonesia raised SBI rate to anticipate
inflation pressure due to fuel price hikes policy executed in
October 2005. Interest spread returned to its downtrend due to
the rise in 1-month SBI rate in the second quarter of 2008. This
is due to Bank Indonesias policy in maintaining the weakening
Rupiah as a result of global economic crisis. As an impact of
global crisis, there has been a vast outflow of foreign funds, in
the form of portfolio investment, as an effort to secure their
investment. As a result, rupiah rapidly depreciates and Bank
Indonesias responded this situation by raising domestic interest
rate to control the weakening rupiah as an impact of global
economic crisis.

Shown below is the movement of lending rate, SBI rate and

implied risk premium (spread) throughout the observation period
from 2002 to 2010.

Figure 4.5 Interest spread and economic growth

It can be seen from graphs shown in Figure 4.5 that the implied
risk premium (spread) is negatively related to economic growth.
Between the second quarter of 2002 to the beginning of 2005,
where high interest rate spread was evident, or in other words,
loose BI monetary policy, the economic growth was in its
downward trend. Furthermore, in the fourth quarter of 2005 to
the first quarter of 2006, anticipating the inflation pressure as a
result of the increase in fuel price on October 2005, Bank

Indonesia raised the BI interest rate. The tight monetary policy is

reflected by a lower interest spread.

IV.2 VAR Analysis

IV.2.1 Unit Root Test
In this section, stationarity test is conducted on several research
variables, namely: real GDP growth, inflation, credit-to-GDP
ratio, interest spread and exchange rate. The test employed is
Augmented Dickey Fuller (ADF) test.
The model used in ADF test is:
p

Yt = + Yt 1 + i Yt i +1 + t
i=2

From the above mode, a hypothesis can be formulated:

Non-stationary data ; stationary data
p

H0 :

=1

Figure 4.6 Inflation and interest spread

Figure 4.6 depicts that implied risk premium (spread) shows a
negative relation to inflation. From the first quarter of 2003 to
the second quarter in 2005, a tendency of high risk premium was
observed, or in other words, a loose monetary policy stance
Bank Indonesia, followed with low inflation rate. Risk premium
was low, followed with inclining inflation rate as a consequence
to government policy on raising fuel price due to oil price hikes.
Negative relationship was also noted at the beginning of 2009 up
to the end of year 2010, with high risk premium followed with
low inflation rate.

(Non stationary data)

p

H0 :

<1

(Stationary data)
p

1
i

Statistical Test: =

p
std. error i
i
Significance: = 5%

Dickey Fuller

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.

Figure 4.7 Exchange rate depreciation and inflation

The above graph shows a positive relation between exchange
rate depreciation and inflation. During the analytical period
between 2002 and 2010, there had been comovements observed
between exchange rate depreciation and inflation rate. To be
specific, in the second quarter of 2005 to 2006 and the fourth
quarter of 2008 to the third quarter 2009, the movement of
exchange rate tends to precede that of the inflation. In general,
there is positive relationship between exchange rate and
inflation.

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 nonstationary. 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 longrun. 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 Johansens
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 Johansens 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 longterm can be executed.
In long-term specification model, several restrictions were
imposed in a long-term equation parameter. First, in the longrun, 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).

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:

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
GROWTH(-1) 26.95074+0.509185 FINDEV ( -1) 3.948655 SPREAD(-1)
=
Quantity Theory of Money, expansion in money supply
results
in inflation. In monetary view, the elevation in total amount of
[-2.57882]
[ 8.00248]
money in circulation encourages the elevation of aggregate
INFLATION ( -1) =
13.79273 0.985913 SPREAD(-1) + 0.015158 XRATE(-1)
demand and excess demand, leading to increase in price level
[ 2.09635]
[ 0.33260]
and wages, whereby this mechanism only happens in short term.
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.

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

premium and inflation are the main contributing factors of shortrun 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.

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

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.

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.
Variance Decomposition of INFLATION
Period
1
6
12
18
24
30
36

XRATE
SPREAD
FINDEV
GROWTH INFLATION
S.E.
0.282013 0.180058 8.867256 1.010217 17.04958
72.89289
1.092094 9.970768 36.06197 4.610009 9.809208
39.54804
1.74729 10.64549 43.48506 23.87836 3.53918
18.45191
2.222245 13.00937
36.525 35.37426 2.501613
12.58976
2.588447 15.80549 31.13252 40.33962 2.27741
10.44496
2.905923 18.03045 27.92656 42.63289 2.083341
9.326761
3.200221 19.5112 25.98069 44.08262 1.910189
8.515301
Cholesky Ordering: XRATE SPREAD FINDEV GROWTH INFLATION

Table 4.7 Variance Decomposition of Inflation

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

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.

Variance Decomposition of GROWTH

Period
1
6
12
18
24
30
36

S.E.
XRATE
SPREAD
FINDEV
GROWTH INFLATION
4.675623 1.224627 12.25342 0.65976 85.86219
0
10.77995 0.578441 49.0602 0.487891
46.3697
3.503765
14.16866 0.137386 66.84135 9.413768 18.79081
4.81669
16.69339 0.095708 64.7816 19.24083 10.56299
5.318876
18.4802 0.17359 61.08808 25.08083
7.72892
5.928587
19.92642 0.279459 58.84812 27.88405 6.578549
6.409827
21.25784 0.357925 57.7011 29.21874 5.999509
6.722718
Cholesky Ordering: XRATE SPREAD FINDEV GROWTH INFLATION

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

2.

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.
Negative relationships are evident between financial
system stability and monetary stability (inflation) as
well as exchange rate depreciation and inflation

a.

3.

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.
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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