Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman,

Kuala Lumpur, Malaysia

1092

Dynamic Properties of an Aggregate Econometric Model of Indonesias Economy

Intan Syahrini
Department of Mathematics, Faculty of Mathematics and Natural Sciences Unsyiah
Intansyah_89@yahoo.com

Abstract. A simple linear dynamic model is specified in this research to lay down the condition of dynamic stability and evaluate the relative importance of fiscal and monetary policy instrument in the short-run and long-run projection equilibrium. The objective is achieved by constructing a linear dynamic macro econometric model of Indonesias economy to determine the values of endogenous variables in term of pure exogenous variables. Data used in this research is time series data from 1990 to 2007. The model used in this study is the simultaneous dynamic model in a simple macro economy in Indonesia which consisting of three behavioral equations is a function of consumption, investment function and the function of interest rate, and an income identity equation. Consumption, Investment and Interest Rate is an endogenous variable, while the Money Supply and Government Expenditure is an exogenous variable. The model stability was determined by characteristic roots which all had modules less than unity. The stability of model was further confirmed by the value of dynamic multipliers which converged to zero as the length of the time lag increased. The results from this study indicate that the model is stable. This means that government spending is an effective tool in boosting the income, although in the long term impact of the policy has very little influence with increasing time lag. Keywords : Dynamic Model, Stability, Dynamic Multiplier

1. Introduction
The use of dynamic models for policy planning and decision-making is widespread in many developed as well as developing countries. One of the most difficult problems is to construct a model that could adequately reproduce the dynamic behavior of an economy. The recent experience in modeling has showed that the policy objectives could be achieved only by recognizing the complex relationship between real and monetary variables. Dynamic model not only can be used to calculate the impact of the multiplayer dynamic and to determine the stability of the model, but also to evaluate the fiscal and monetary policy. The purpose of this paper is to build a dynamic macro-economic of simple linear model in Indonesia. Analysis of this model is to determine the values of

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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endogenous variables, especially income of purely exogenous variables. In order to establish the dynamic stability of the model, we seek to present the "necessary condition" that will dependent not only on the structure of the model, but also on the estimated parameters of structural equations. After the stability of the model, the next step is policy evaluation. In this case, the impact of dynamic multiplayer will be very influential. Multiplayer is then used to determine fiscal and monetary policy on income and other dependent variables such as consumption and investment. The time period under consideration range between1990 to 2007. The rest of the paper is organized as follows. In section 2 the model is specified. Section 3 explains the methodology for dynamic analysis. Results of estimation and the impact and dynamic multipliers are reported in section 4 and the final section contains the summary and conclusions.

2. Specification of the Model

The model used in this research is a simple linear of Dynamic Macroeconomic model in Indonesia which include three behavioral equations for consumption, investment and interest rate, and an income identity equation. The specification of the behavioral equations is as follows. Consumption Function Consumption expenditure function is hypothesized to depend on the income variable (Yt) and lagged Consumption variable (Ct-1). Symbolically, this relation can be stated as :
C t = 0 + 1Yt + 2 C t 1 + 3 Rt + t1

Where t1 is the random disturbance term which is assumed to have zero mean and finite variance. Investment Function An investment function with accelerator has previously been estimated for the large-scale manufacturing sector of Indonesia. Investment, in the present paper, depends on the following list of explanatory variables. Aggregate income (Yt), lagged aggregate income (Yt-1), interest rate (Rt), lagged investment (It-1), and lag interest rate (Rt-1). The inclusion of lagged investment is justified on the grounds that the actual investment never adjust to the desired level instantaneously. Thus, the investment function is determined as: I t = 0 + 1 I t 1 + 2Yt + 3Yt 1 + 4 Rt + 5 Rt 1 + t 2

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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Interest Rate Function Interest rate function is to depend on the income variable (Yt), Money Supply variable (Mt), and lagged interest rate (Rt-1). Thus, the Interest Rate function is determined as:
Rt = 0 + 1Yt + 2 M t + 3 Rt 1 + t 3

The Identities of the Model Along with the above behavioral equation, the mode also includes the following definitional relationship.
Yt = C t + I t + Gt

where Gt denotes Government expenditure.

3. Methodology for Dynamic Analysis

3.1. Reduced Form Model Using matrix notation, the structural form model will be:
B ( L)Yt + C ( L) Z t = U t

(3.1)

where m endogenous variables and hence m equations are represented by Yt , Z t are k exogenous variables and u t is vector of error terms. The lag operator defined by LWt = Wt 1 is used with the following explanation:
B ( L ) = B0 + B1 L + ...... + B g Lg C ( L ) = C 0 + C1 L + ..... + C r Lr

Here B0 is subject to normalization. Expression (3.1) can now be used to derive the reduce form model that expressed Yt (and other endogenous variables) in term of predetermined variables as:

Yt = B01 [ B1Yt 1 + ..... + Bg Yt g ] + [( B0 ) 1 C ( L) Z t + B01u t

(3.2)

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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where g denotes the lag structure of predetermined variables. 3.2. The Final Form Since the reduce form include lagged values of endogenous variables other than the one under consideration, we need to eliminate these by successive substitution. The final form resulting in this case expressed each endogenous variable in terms of an infinite distributed lag of exogenous variables. This is
Yt = B ( L) 1 C ( L) Z t + B ( L) 1 u t

(3.3)

Finally, to determine the influence of exogenous shocks on the time path of endogenous variable ( Yt ), it is desirable that all lagged values of Y should also be eliminated from the final form. Successive substitution starting from the first period yields the final equations as follows;
Yt = b( L )C ( L) b( L ) Zt + ut B( L) B ( L)

(3.4)

where b(L) is the adjoin matrix of B (L ) 3.3. Condition for Dynamic Stability Before analyzing the impact of policy variables on aggregate income, it is essential to prove that the model under consideration is dynamically stable. Model stability could be assessed by setting the right-hand side of the fundamental dynamic equation equal to zero. This manipulation yields the following characteristic equations.

B0 Y

g t

+ B1Yt g 1 + ....... + B g 1Yt + B g = 0

(3.5)

The model will be dynamically stable if all roots of characteristic equation have modules less than one (|m|< 1)
3.4. Impact and Dynamic Multipliers

With no loss of generally the model (3.1) can be presented as a first order system of stochastic difference equations. That is :
A Yt = B t 1 + C Z t + u t

(3.6)

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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where
Yt is a mx1 vector of dependent variables;
Z t is a kx1 vector of exogenous variables; B and C are the matrices of parameters with conformable dimensions; u t is mx1 vector of error term which are assumed to be serially uncorrelated.

This reduced form in this case will be

Yt = 1 Yt 1 + 2 Z t

(3.7)

where the Yt 1 is the lagged endogenous variable, Z t is the set of pure exogenous variables, 1 = A 1 B is mxm matrix of coefficients for predetermined variables, and 2 = A 1C is mxk matrix of coefficients for exogenous variables. Expression (3.7) can now be used to evaluate the change in aggregate income in response to a change in any of the exogenous variables. 2 in this case will be the impact multipliers. Since a one shot or sustained shock in the exogenous variable continues to have a long-run effect on dependent variables, the exact value of change could be measured by computing multipliers for subsequent periods generally known as the dynamic multipliers. The value of dynamic multipliers could be generated as follows:

( I + 1 ) 2 ( I + 1 + 12 ) 2 M M ( I + 1 + ..... 1j ) 2 If the matrix 1 is such that or equilibrium multipliers will be:

for the effect after one period for the effect after two period

for the effect after one period 1j 0 as j then the total long-run

j 1 j 0

= ( I 1 )1 2

where (m, k )th element describes the change in equilibrium or long-run level of Ym due to a unit change in Z k .

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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4. Results of Estimation
4.1. Regression Results

Equation below is a function of consumption, investment, the Interest Rate, and the identity of income equality. The model consists of four equations and four endogenous variables (Ct, It, Rat, Yet) and two exogenous variables (Mt, Get). The model is estimated using Two Stage Least Squares (2SLS). The results of the estimation are:

C t = 282740 + 0.11461Yt + 1.0644 C t 1 + 15093 Rt (1.921) (0.3899 ) (0.6980) (1.962) (4.787)

Yt = C t + I t + Gt

(2.403)

(2.356) (0.1575) (0.2656) (2.592)

I t = 85749 + 0.43068 I t 1 + 0.055724 Yt + 0.11589 Yt 1 762.61 Rt 3999.3 Rt 1 (0.3475) (0.6641) Rt = 22.245 0.000016652 Yt + 0.000099094 M t 0.057468 Rt 1 (1.705) (1.289)

The consumption function above, we can explain that all the independent variables affect positively on the dependent variable. On the basis of summary statistics the results show fairly consistent behavior across alternative estimation techniques. The results of investment functions can be drawn that all independent variables affects positively except the current and the past interest rate variables While the function of interest rates, money supply current year affects positively on consumption, on the other hand the current income and the interest rates last years have a negative impact on consumption. The estimated coefficients suggest that a one unit increase in income leads to an increase in investment by 0.056unitsdepending upon the choice of estimation technique. Finally, the estimated for interest rate show that the money supply increases proportionally.
4.2. Dynamic Analysis

In the present paper, we have adopted Walliss procedure (1973) to establish the stability of the model and to derive the impact and the dynamic multiplier. In this respect, stability of the model is determined by calculating the Eagan value of 1 in (3.7). Supposing that the Eigen value are given by j where i = 1,2,....., m ( where m1 > m) , then stability requires that all non-

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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zero Eigen value of det[( B0 ) 1 B I ] = 0 be less one in modules, with I being an mxm identity matrix. For the model above we obtained four non-zero latent roots. That is;

1 = 2 = 3 = 4 =

0.00099635340000 0.00040310940000 - 4.51451700000000 0.00010848120000

Since the magnitude of these roots is less than unity, the solution will be stable. Short-term effects of changes in exogenous variables or lagged endogenous variables on endogenous variables are shown in a system of linear equations that is the value of the matrix 1 and 2 . Matrix 2 is also called matrix Impact Multiplier. - 0.5511256E- 01 - 250.1459 - 0.1483140E- 01 0.9281799 0.6817347E- 01 0.4582219 - 4264.371 0.1233126 1 = - 0.1659128E- 04 - 0.6712577E- 05 0.1770774E- 01 - 0.1806429E- 05 0.4031094 - 4514.517 0.1084812 0.9963534 and
2 =

37417.50 76585.14 20.34663 114002.6

1.313889 - 0.1279783 0.1538269E - 01 0.6404873E - 01 0.7695896E - 04 - 0.1558745E - 04 1.329272 0.9360705

From 2 that the addition of 1 unit money supply will increase consumption, investment, interest rates, and aggregate income respectively 1.33 unit, 0.02 unit, 0.00007 unit, 1:33 unit and. Instead of increasing government expenditure by 1 unit led to declining consumption and the interest rate by 0.13 unit and 0.00002 unit, but will improve the investment and income amounted to 0.64 unit and 0.93 unit. These shows that in the short-term money supply and government expenditure have a very small effect on changes in interest rates.

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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The dynamic multipliers for the time path of GNP are presented in table 1. The multiplier of government expenditure converges to zero with the increase in the length of time lags. Otherwise, the multiplier of money supply does not converge to zero with the increase in the length of time lags. Furthermore, positive change in money supply has a stimulating effect on GNP although the impact effect of former is less than the letter. It may be noted, however, that the effect of the money supply operated through the interest rate in the investment demand function. The long-run multiplier for government expenditure and money supply are obtained by summing the impact and the dynamic multiplier in table below. The long-run multiplier for these two policy variables are 88.59052 and 4.740878 respectively. These results confirm that government expenditure and money supply are effectively policy tool is influencing the target variables. Although the superiority of either of these instruments from such a simple model will be a tall claim, nonetheless, the result from simple linear model will result fiscal interventions
Table 1: Dynamic Multipliers for the time path of GNP Multiplier of No. of Money Government lags Supply Expenditure 1 2.441339 1.006293 2 3.813686 0.9649671 3 5.258405 0.8605986 4 6.681424 0.7224405 5 8.025110 0.5700804 6 9.2580 0.4161225 7 11.92860 0.2428069 8 12.90914 0.1056399 9 13.76633 -0.1868001E-01 10 14.50846 -0.1293912 88.59052 4.740878

5. Summary and Conclusions

A simple linear dynamic model is specified in this paper to lay down the conditions of dynamic stability and evaluate the relative importance of fiscal and monetary policy instruments. The model stability was determined by characteristic roots which all had modules less than unity. The stability of the model was further confirmed by the value of dynamic multiplier of government expenditure which converged to zero as the length of the time lag increased. It was observed that government expenditure was effective tools in stimulating

Proceedings of the 6th IMT-GT Conference on Mathematics, Statistics and its Applications (ICMSA2010) Universiti Tunku Abdul Rahman, Kuala Lumpur, Malaysia

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income although the effect of these policy tools became mild as the time lag increased.

References
1. Safety, S. Mc. Macroeconomic Theory, Harper & Row, ,Inc, USA (1990). 2. Chiang, A.C. Fundamental Methods of Mathematical Economics. The McGraw-Hill Companies, Inc. USA (1984) 3. Greene, William H. Econometric Analysis. Sixth Edition. International Edition. Prentice Hall. New Jersey (2008) 4. Pyndick, Robert S, Daniel L Ruined. Econometric Models & Economic Forecast. Fourth Edition. The McGraw-Hill Companies, Inc. USA (1998) 5. Ramanathan, Ram. Introductory Econometrics with Applications. Third Edition. The Dryden Press. Orlando (1995)