In Brief

Bank Indonesia has announced that it is considering the use of a change in the required reserve ratio as a possible method of bringing inflation under control. This ratio specifies the amount of deposits commercial banks must hold at the central bank as a proportion of their own customers’ deposits. Banks’ deposits at BI are a component of base money, so increasing the ratio has the effect of artificially increasing the demand for base money. With a fixed supply, increasing the reserve ratio therefore creates an excess demand for base money, putting upward pressure on interest rates and, consequently, downward pressure on inflation.

The obvious question here is: why not simply increase official interest rates, such as those on Bank Indonesia Certificates (SBIs)? Increasing the SBI rate allows more SBIs to be sold, which decreases the supply of base money and likewise therefore creates excess demand for it, resulting in increased interest rates throughout the market. In terms of the inflation outcome, it really doesn’t matter which of these two instruments is used.

My guess is that the only reason why BI would consider reverting to the rather old-fashioned policy of varying the required reserve ratio is that this allows it to escape the odium attached to directly increasing interest rates.

But that is only a short term political gain. In the slightly longer run, it will be obliged to increase SBI rates to the now higher level ruling in the market. If it does not, it will find it difficult to sell sufficient quantities of SBIs, which will result in an excess supply of base money and a consequent further boost to inflation. The appropriate way forward is simply to increase SBI rates directly.