The dynamic interaction between monetary and fiscal policies in Indonesia

Kuncoro, Haryo; Sebayang, K. Dianta A. Article The dynamic interaction between monetary and fiscal policies in Indonesia Romanian Journal of Fiscal Policy (RJFP) Provided in Cooperation with: Romanian Journal of Fiscal Policy (RJFP) Suggested Citation: Kuncoro, Haryo; Sebayang, K. Dianta A. (2013) : The dynamic interaction between monetary and fiscal policies in Indonesia, Romanian Journal of Fiscal Policy (RJFP), ISSN 2069-0983, Editura ASE, Bucharest, Vol. 4, Iss. 1, pp. 47-66 This Version is available at: https://hdl.handle.net/10419/107951 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by-nc/3.0/ Romanian Journal of Fiscal Policy Volume 4, Issue 1(6), January-June 2013, Pages 47-66 The Dynamic Interaction between Monetary and Fiscal Policies in Indonesia*) Haryo KUNCORO and K. Dianta A. SEBAYANG Faculty of Economics, State University of Jakarta ABSTRACT The aim of this paper is to analyze the dynamic interaction between monetary and fiscal policies in Indonesia for the period of 1999-2010. First, we propose the reaction function between monetary and fiscal policies. Second, we identify the main determinants of both interaction decisions, i.e. interest rate and primary balance surplus. The results of quarterly data estimation show that in the short term monetary policy reacts as expected to the fiscal policy – in the sense that governments have the ability to run a primary surplus. This action makes fiscal sustainability easier to achieve in the long run. On the other hand, fiscal policy marginally reacts to the monetary policy (interest rate) so that fiscal sustainability will be more difficult to attain given the opposite response of governments to public debt shocks. Furthermore, the interaction matrix indicates that monetary policy is more dominant in Indonesia. In these circumstances, the active fiscal policy should be made in order to reach economic growth sustainability in the long run. Keywords: Monetary Policy, Fiscal Policy, Interest Rates, Primary Surplus JEL Code: E58, E62, E63 1. Introduction The issue of fiscal deficit is well debated area in macroeconomic literature due to its effects on the indicators of macroeconomic performance such as inflation and growth and its impact on financing and proceeding debt dynamics. When the inter-temporal budget constraint is satisfied without the change in either policy or the price level, the current fiscal policy is said to be sustainable (see for example: Dihn, 1999). If the government adjusts primary deficit to limit debt *) The earlier version of this paper has been presented in the Malaysia-Indonesia International Conference on Economics, Management, and Accounting held by University of Bengkulu Indonesia on October 13-14, 2011. The authors would like to thank all participants for invaluable comments. However, any errors, confusions, and shortcomings which may remain are our responsibility. 48 accumulation and the central bank does not monetize debt, such a regime is called monetary dominant or Ricardian regime (Sargent and Wallace 1981). However, fiscal deficit causes inflation because governments find money creation to finance the deficits leading to inflation as a monetary phenomenon. Such regime is called fiscal dominant or non-Ricardian regime. The fiscal theory of price level argues that a fiscal dominant regime may arise when fiscal policy is not sustainable and government bonds are considered net wealth (Barro, 1974). These wealth effects could make difficult to meet the objective of price stability, irrespective of the central bank commitment to low inflation (Woodford, 1994 and 1998; Leeper, 1991; Sims, 1994, and Cochrane, 1998 and 2001). The implication is that in fiscal regime the government’s fiscal policy is sustainable through debt deflation, that is, an increase in prices that erode the real value of public debt and in turn the real value of financial wealth until demand equals supply and a new equilibrium is reached. Therefore, prices are determined by fiscal policy, and inflation becomes a fiscal phenomenon. Price stability is an important goal of the monetary policy in Indonesia. Since 1999, Indonesia has implemented a new law for the central bank. The law stated that the Central Bank of Indonesian must be independent from interventions of political pressure and the central government in conducting its monetary policy. Moreover, the central bank is only responsible for price stabilization as a one goal policy rather than multiple objectives which are stated in the previous law. Furthermore, since June 2005 Indonesia has implemented inflation targeting in the monetary policy frameworks. The present study attempts to estimate the dynamic interaction of fiscal and monetary policies for economic stability in Indonesia. This seems interesting because firstly, data indicate that public debt and fiscal imbalances are on the rise causing concerns about fiscal sustainability. This suggests that some form of fiscal dominance become an issue for Indonesia. Secondly, so far, no systematic empirical work to discriminate between these two regimes monetary dominant and fiscal dominant, has been conducted. The only literature available is (De Brouwer, Ramayandi, and Turvey, 2006; Indrawati, 2007; and Ramayandi, 2007) which investigates the relative importance of fiscal and monetary policy on aggregate economic activity. A few studies devoted to analyze the interaction between monetary and fiscal policies (Artha, 2007; ADB, 2010) and fiscal sustainability (Santoso, 2004; Kuncoro, 2011a). Thirdly, the principles of fiscal theory of price level require that it is necessary to have appropriate fiscal policy and also an adequate monetary policy to achieve price stability. Unless specific measures are taken to ensure an appropriate fiscal policy, the objective of price stability may not be achieved despite the independence of the Central Bank of Indonesia and its commitment to low inflation. Those motivate to assess the empirical plausibility of both fiscal and monetary dominant regimes in case of Indonesia’s economy. The plan of rest of study is as follows. Section 2 reviews briefly the empirical literature on the relative importance of fiscal and monetary policy for price stability. The empirical methodology to differentiate between monetary and fiscal dominance 49 and data are discussed in section 3. The empirical results are provided in section 4 and the last section offers conclusion. 2. Literature Review The theoretical case for delegating monetary policy was firstly formalized by Kydland and Prescott (1977) and Barro and Gordon (1983). They concerned to the time inconsistency of a discretionary monetary policy. Barro and Gordon (1983), for example, explained that the policy maker has a cost function which consists of two elements; they are cost of inflation in quadratic form and the benefit from surprise inflation (actual inflation exceeds the expected inflation). For authorities, the decision of either monetary or fiscal policy (or even both) is derived from the utility function of both authorities in which contains their preferences on macroeconomic variables and devotes to minimize the loss function. Simply, Taylor (1993) initiated the model of monetary policy reaction function*). He proposed that the objective function is monetary policy (i.e. federal fund rate, r) and the loss function is output gap (y, the difference between actual GDP and potential GDP, y*) and the inflation gap (p, the difference between actual inflation and projected inflation rates, p*). For monetary authority point of view, there can be other objective functions such as stabilizing exchange rate and safeguarding the balance of external payments (expressed by difference between actual exchange rate, e, and the exchange rate targeted, e*) and maintaining financial stability in money market (M exceed from its targeted, M*). Even, in some cases, the central bank is assigned to finance primary balance deficit (PB exceed from the PB targeted, PB*). The general utility function for monetary authority is as follows: Um = f { (r-r*) , (p-p*) , (y-y*) , (e-e*) , (M-M*) , PB } (1) Um = m1 {max (r-r*, 0)}2 – m2 {min (p-p*, 0)}2 – m3 {min (y-y*, 0)}2 – m4 {min (e-e*, 0)}2 – m5 {min (M-M*, 0)}2 – m6 (PB-PB*}2 (2) which states that the monetary authorities move the nominal interest rate (r) above (below) neutral when other macroeconomic variables are above (below) the target level respectively. In this case, the nominal interest rate is endogenous variable for central bank and would be a monetary instrument to absorb macroeconomic shocks. The similar idea is adapted in fiscal policy. Likewise Barro and Gordon (1983), according to Beetsma and Bovenberg (1997), the surprise inflation erodes the real value of outstanding nominal public debt. Furthermore, Beetsma and Uhlig (1997) argued that government has the incentive to restraint debt accumulation. Therefore, the introduction of limit on debt will reduce the incentive of government to conduct excessive fiscal deficit and to accumulate debt. *) After Taylor, there are many extended monetary reaction function models, such as Obstfeld and Rogoff (1995), Ball (1999), Svensson (2000), Taylor (2001), Gali and Gertler (2007), Troy and Leeper (2007) and others. 50 Restraint debt accumulation is one of the fiscal solvency and sustainability requirements (Dihn 1999). Therefore, the authority’s objective function is fiscal sustainability as presented by primary balance surplus (total government expenditure minus debt services payment). The loss function is output gap (representing government revenues gap), inflation rising beyond a desired level, and the cost of public debt (interest rates gap). The fiscal authority utility function is as follows: Uf = f { (PB-PB*) , (p-p*) , (y-y*) , r } (3) Uf = f1 {max (PB-PB*, 0)}2 – f2 {min (p-p*, 0)}2 – f3 {min (y-y*, 0)}2 – f4 (r-r*)2 (4) subject to the government budget constraint: PBt = Dt-1 + St (5) where PB is primary balance, RD is debt to output ratio, and S is seignorage (or equivalently M in equation (1)). Equation (5) can be interpreted as a fiscal rule to achieve fiscal sustainability, with the rule defining the primary balance/GDP ratio required to keep to such a debt/GDP target. We assume that the monetary authority cares more for inflation hikes than the fiscal authority does. Conversely, the fiscal authority is more concerned about output drops than its monetary counterpart is. Thus, the divergent authorities’ preferences reflect both the central bank’s mission to contain inflation and the voters’ aversion to unemployment (output gap) that the fiscal authority has to deal with. Conceivably, expansionary fiscal policy may at some stage become ineffective as a means to stimulate demand and, similarly, fiscal contractions may turn out to be expansionary. When economic agents realize that the government is borrowing too much for its own good, they will conclude that this can only lead to higher taxation levels in the future, and they may decide to compensate for that already now by saving more and consuming less. This means that the financial behavior of economic agents—on which the central banks base their monetary policy decisions—depends on their perception of fiscal sustainability. It should be noted that the impact of fiscal policy on the central bank objectives is not automatically avoided when the central bank is independent. Even when the central bank has independence, and hence is not submitted to the fiscal needs of the government, the need to offset the impact of expansionary fiscal policy on aggregate demand and inflation in the economy could prompt the central bank to tighten monetary policy, by raising interest rates or reducing credit in the financial system. The resulting high interest rates could depress economic activity, attract short-term and easily reversible capital in flows—thereby adding to inflation and appreciation pressures on the currency, and eventually damaging macroeconomic and financial stability. Severe budgetary problems may even lead to high real interest rates. This intensified the government’s debt-servicing costs, causing a build up of short term and foreign currency-linked public debt, thus increasing the sensitivity to interest rate, exchange rate, and rollover risks, which materialized as foreign capital inflows that had helped to finance the debt were suddenly 51 reversed. Even in countries where such extreme conditions did not materialize, the sustainability of the monetary regimes can be challenged by fiscal policies that are too accommodating. High interest rates— required to contain inflation—attracted capital inflows that complicated the implementation of monetary policy. Sterilization of capital inflows to keep inflation under check became increasingly difficult and costly for the central bank. Empirically, there are extensive studies regarding the interaction of monetary and fiscal policy. In 1970s, the issue was centred on the inflationary consequences of the monetary financing of the fiscal deficit. Some economists such as Kydland and Prescott (1977) and Rogoff (1985) suggested that monetary policy should be determined by rules rather than discretion strategy. They proposed that monetary policy should be controlled by independent authority. Therefore, the new environment of macro-economic policies in form of the separation between monetary and fiscal policy arose. Fase and den Butter (1977) estimated the reaction function of the central bank in Netherlands. They found that the movement of interest rates in the domestic and foreign money market and the development of the trade cycle, measured by the rate of unemployment, were the main determinants of the discount rate policy. However, in the 1990s, economists such as Nordhaus, Schultze, and Fischer (1994) explored theoretically that the possible outcomes depend on the degree of independence or coordination between monetary and fiscal policy. According to their study, the separation of monetary and fiscal authority will provoke high fiscal deficit and high interest rates that are too high to promote a healthy level of private investment and adequate long-term growth of potential output. Recently, the debate on the optimal relationship between monetary and fiscal authorities has been a big issue in macroeconomic policy. Judd and Rudebusch (1998) reviewed previous works and maintained that the Taylor rule is a valuable guide to characterize major relationships among variables in conducting monetary policy. Romer (2001) analyzed several issues in applying the Taylor rule. The values for the coefficients of the output gap and the inflation gap would change the effectiveness of monetary policy. Thereafter, Beetsma and Bovenberg (1997) proposed the need of coordination between monetary and fiscal authority. Not only monetary authority should conduct monetary rule but also fiscal policy should set the rule for fiscal deficit. A new approach, which allows fiscal policy to set primary surpluses to follow an arbitrary process, does not necessarily compatible with solvency. Therefore, the budget surplus path would be exogenous, and the endogenous adjustment of the price level would be required in order to achieve fiscal solvency. In this context, fiscal policy becomes “active”, with budget surpluses turning to be the nominal anchor; whereas monetary policy becomes “passive” and can only control the timing of inflation. Accordingly, some empirical studies have emerged more recently on the implications of fiscal theory of the price level on inflation targeting in open economies and for the case of monetary unions; see, e.g., Sims (1997), Woodford (1998), Bergin (2000), Canzoneri, Cumby, and Diba (2006), and Ballabriga and Martínez-Mongay (2003). Muscatelli, Tirelli, and Trecroci (2004) examined the response of monetary and fiscal policy to the macroeconomic in a number of G7 countries. They found that, whilst monetary and fiscal 52 policies are increasingly used as strategic complements, the responsiveness of fiscal policy to business cycle has been decreased. From a different perspective, Dixit and Lambertini (2001) in a game theory framework argue that although they could have the same objectives, the weight fiscal and monetary authorities attribute to final targets in terms of output and inflation differs in such a way that a race between both authorities could lead to equilibrium levels far away from the targets, concluding that the coordination in targets between both authorities is essential. In the case of emerging market countries, Tanner and Ramos (2002) evaluate whether the policy regime in Brazil during the 1990s can be better characterized as fiscal or monetary dominant. For Brazil, Loyo (2000) and Fialho and Portugal (2005) find evidence consistent with the fiscal theory of the price level where a tight monetary policy along with lose fiscal policy resulted in hyperinflation even without seignorage increase. Baldini and Ribineiro (2008) find in case of Sub-Saharan Africa a mixed e.g. some countries are dominated by fiscal regime other by monetary regime and other have no clear result. They also find the changes in nominal debt effect price variability via aggregate demand effects suggesting the fiscal outcomes could be direct source of inflation variability, as predicted by the fiscal theory of price level. Cashin et al. (2003) and Khalid, Malik, and Sattar (2007) have examined the fiscal policy sustainability for Pakistan. In the case of Indonesia, Juhro (2008) observed the superiority of interest rate as a policy variable, or an operational target, against monetary base. De Brouwer, Ramayandi, and Turvey (2006) noted that for Indonesia the current interest rates seem to be still higher than what the rule suggested. Hsing (2008) suggested modifying the rule because the monetary policy in Indonesia does not react to the change in real exchange rate and would be more responsive to a change in the inflation rate. However, according to Ramayandi (2007), Indonesia seems to still be able to handle the inflation pressure without having to increase the interest rate. The most interesting result of his study is that the adjustment to achieve the actual interest rates is lowest compared to the selected Asian countries. Thus, the actual interest rate is representative to the inflation rate. ADB (2010) noted that the track record of Indonesia in keeping inflation in the range was not so good. The target range is fairly narrow, and the inflation rate was more volatile than in other economies; hence the target was missed from time to time. In Indonesia, the narrow band is not only changed from year to year but also highly influenced by the budget assumptions set by the Ministry of Finance. In relation to budget assumptions, Santoso (2004) assessed fiscal sustainability using fiscal policy reaction function. He found that Indonesia’s state budget is sustainable. Kuncoro (2011a), in contrast, found that Indonesia’s state budget is unsustainable due to the high cost of domestic debt rather than foreign debt. Further, Kuncoro (2011b) emphasized that the unsustainable fiscal policy has negative impact of financial stability. Linking monetary and fiscal policies, Artha (2007) found that the Central Bank independence in Indonesia really brought about a shift in monetary policy from a reaction on cyclical developments to a reaction on inflation. Moreover, monetary policy is not responsive to the 53 fiscal policy especially in the pre-inflation targeting periods. From the estimated fiscal authority’s reaction function, he found that the movement of inflation and unemployment is not significantly determining fiscal surplus. Hermawan and Munro (2008) suggest that fiscal policy contributes meaningfully to macroeconomic stabilization in Indonesia, leading to better outcomes than monetary policy alone. Mochtar (2004) analyzed the fiscal and monetary interaction and found that the economic crisis has generated quasi fiscal activities by the central bank. Further result also shows that though it can be classified in weak form with respect to the recent fiscal reform measures introduced by the government to bring down its deficits, fiscal policy play in a dominance role in fiscal and monetary interaction in Indonesia post 1997. Indrawati (2007), in a broader scope, investigated the relative importance of fiscal and monetary policy on aggregate economic activity. She found that fiscal shocks have negative and permanent impacts on inflation rate and responded by tight monetary policy. Meanwhile, monetary shocks have negative and permanent impacts on economic growth. The results of these studies seem to suggest that fiscal dominance might be an issue for emerging economies more than for developed ones. This motivates to test the fiscal dominance in case of Indonesia. 3. Research Method According to theoretical framework explained in the previous section, the reaction function of monetary and fiscal authorities is derived from the utility function of both authorities in which contains their preferences on macroeconomic variables. However, the theoretical framework is not specific enough to serve as an econometric model. To develop econometric model, it is necessary to choose the relevant target variables for monetary and fiscal policy. Since monetary and fiscal policies are stabilization policy, we assume that output growth and price stability are relevant targets. Besides the above target, the other variables which are expected to play a role in explaining the central Bank of Indonesia behavior in determining domestic interest rate are foreign interest rate, money supply growth, and government policy. To set domestic interest rate (i.e. SBI, Sertifikat Bank Indonesia), the Central Bank of Indonesia always refers to US interest rate. So, it is necessary to introduce the relative interest rate, SBI/R. The government policy is represented not only by government budget surplus but also debt stock to incorporated fiscal stance. The two measurements of fiscal stance are presented in the relative terms to GDP. Due to the inflation rate in Indonesia is closely related to oil price, we enter the later to be explanatory variable. As explained previously, since June 2005 Indonesia has implemented inflation targeting in the monetary policy frameworks. To accommodate the shift in monetary policy and referring to the study of Artha (2007), Hsing (2008), Ramayandi (2007), and ADB (2010), we also add dummy variable to capture inflation targeting implementation (DIT). We set d = 0 for the period before June 2005 and d = 1 for the rest periods. The econometric model for monetary reaction function is postulated as the following linear specification: 54 SBI/R = M0 + M1 INF + M2 GAP + M3 DM + M4 DEP + M5 OP + M6 RPB + M7 RD(-1) + M8 (SBI/R)(-1) + M9 DIT (6) where: SBI/R = SBI to US interest rate ratio INF = inflation rate GAP = output gap DM = relative change of real money supply DEP = depreciation rate Rupiah against US Dollar OP = oil price RPB = ratio primary balance to GDP RD = Debt to GDP ratio DIT = dummy for inflation targeting Since the Central Bank of Indonesia concerns to price stabilization, we assume that M1 is positive or > 0 means that if the inflation rate increases, the Central Bank of Indonesia will conduct tight monetary policy by raising SBI rate as its instrument. With regard to output gap, we assume that M2 < 0, the higher output gap, the lower SBI rate set by the Central Bank of Indonesia. Theoretically, the difference between actual GDP and potential GDP shows cyclical situation of economy. When actual GDP is higher than potential GDP, unemployment decreases. On the other hand, when actual GDP is lower than potential GDP, unemployment increases. The latter means an inverse relationship between inflation and unemployment, as postulated by the Phillips curve. The money supply variable also plays important role in determining behaviour of SBI rate. When money supply increases, the Central Bank of Indonesia will raise SBI rate to attain targeted money supply. Therefore, M3 is expected to have positive sign. The slope of fiscal and monetary reaction function can be determined by the sign of M6. According to the game, the reaction function of both authorities is negative (M6 < 0) and the slope of the reaction function of fiscal authority is less in absolute value than that of the monetary authority. As SBI rate should follow foreign interest rate, we assume that M8 < 0. The lagged SBI/R rate is introduced because we allow a partial adjustment of the actual to the optimal SBI/R rate, with M8 the coefficient of adjustment. If M8 = 0 means a complete adjustment within each period. The other coefficients of regression could have negative or positive sign. Monetary policy (represented by BI Certificates relative to US interest rate (SBI/R)), foreign exchange rate, oil price, and money supply growth are also expected to have significant role in explaining government policy. The foreign exchange rate and oil price is accompanied to the model because they are used as basic assumption to set budget state. Refer to equation (5), the econometric model for fiscal reaction function is postulated as the following linear specification: RPB = F0 + F1 INF + F2 GAP + F3 DM + F4 DEP + F5 OP + F6 (SBI/R)(-1) + F7 RD(-1) + F8 RPB(-1) (7) 61 Figure 1 Scatter Plot of Interest Rates and Primary Surplus Projected In achieving the main goal each, both policies will always have a deviation from the intended target in spite of the adjustments have been held. The negative deviation means that the policy is too high (expansive) from the target. Conversely, a positive deviation means that the policy had been pursued too low (contractive) from the target. The policy is said to be appropriate and optimal if there is no deviation. Plot of deviations of monetary (RES1) and fiscal (RES2) policies during the study period is presented in Figure 2. 0 5 10 15 20 25 30 35 99 00 01 02 03 04 05 06 07 08 09 SBIF Forecast: SBIF Actual: SBI Forecast sample: 1998:4 2009:4 Adjusted sample: 1999:1 2009:4 Included observations: 44 Root Mean Squared Error 2.435505 Mean Absolute Error 1.796192 Mean Abs. Percent Error 17.72503 Theil Inequality Coefficient 0.094769 Bias Proportion 0.089514 Variance Proportion 0.000485 Covariance Proportion 0.910001 0 2 4 6 8 10 12 14 99 00 01 02 03 04 05 06 07 08 09 RPBF Forecast: RPBF Actual: RPB Forecast sample: 1998:4 2009:4 Adjusted sample: 1999:1 2009:4 Included observations: 44 Root Mean Squared Error 0.597678 Mean Absolute Error 0.487668 Mean Abs. Percent Error 8.645164 Theil Inequality Coefficient 0.041205 Bias Proportion 0.005082 Variance Proportion 0.007702 Covariance Proportion 0.987216 62 Figure 2 Deviation of Monetary and Fiscal Projection Figure 2 shows that monetary policy has more deviations smaller than fiscal policy. This still can be understood conceptually. The monetary policy is more quickly taken despite a time lag. Instead fiscal policy can not be immediately taken, although the time lag it can be felt more immediately. The optimal point that could be investigated from Figure 2 is in early 2002, mid 2005, and the first half of 2008. The explanation can be posited is that early 2002 is the disbanding of the CGI (Consultative Group on Indonesia), a group of donors who give Indonesia's debt. Mid-2005 is the start of inflation targeting and the first half of 2008 was the issuance of fiscal stimulus to mitigate that impact the financial crisis. Overall, the deviation of interaction between monetary and fiscal policies is summarized in Table 4. It includes an active monetary/fiscal policy (expansive) and passive (contractive). Of the 44 samples, monetary policy occurs 19 times passive and the remaining 25 cases are active. The active fiscal policy comprises 24 cases and 20 other cases are passive. The combination of active and passive policies between the monetary and fiscal policy generate the optimal pay-off that is 11 based on the mini-max and maxi-min criteria. Pay off 11 is in the active column. In general, monetary policy is more dominant for the case in Indonesia. Therefore, the optimal interaction is when both monetary and fiscal policies are active (expansive). In this circumstance, the prudent monetary policy followed by sound fiscal policy would probably be the best choice of an optimal policy mix in Indonesia. -1.2 -0.8 -0.4 0.0 0.4 0.8 1.2 99 00 01 02 03 04 05 06 07 08 09 RES1 RES2 63 Table 4 Interaction Matrix and Pay off between Monetary and Fiscal Policy Interaction Monetary Policy Total Maxi-min Criteria Fiscal Policy Pay off Passive Active Passive 10 14 24 14 Active 9 11 20 11 Total 19 25 44 - Mini-max criteria 9 11 - 11 5. Concluding Remarks The present study provides quantitative evidence for the relative importance of fiscal and monetary sources of inflation and traces out the dynamic response of interest rate and primary balance surplus to different shocks, including the public debt. For Indonesia, the evidence is clear to infer that authorities are following a certain type of monetary regime during the sample period 1999-2009. The debt stocks respond positively to the innovation in surpluses, that is in the subsequent period the liabilities decreases in the face of decrease in surplus. This characterizes MD regime, the events that give rise to surplus innovation are likely to persist causing the rise in the future surpluses and surpluses pay-off some of the debt causing the change in the liabilities. By analyzing the behaviour of monetary and fiscal authorities, an innovation in surplus induces interest rates and the later does not increase the surplus ratio in the corresponding period; this analysis confirms the non-Ricardian analysis. On the other hand, the study finds that, as predicted by the fiscal theory of price determination, the occurrence of wealth effects of changes in nominal public debt may pass through to prices by increasing inflation variability. In addition, the results show that as predicted by fiscal theory of price determination the discount rate is decreasing in response to positive shock in inflation. The reverse also happens as the reserve money growth also responds negatively as predicted by the MD regime. Therefore, the implication that comes out of this study is that nominal public liabilities, as reflected either in money growth or in nominal public debt, matter for price stability in case of Indonesia. However, the monetary and fiscal policies significantly do not consider the output gap. Furthermore, the application of game theory indicates that monetary dominance exists in Indonesia. Given that, the prudent expansionary fiscal and monetary policies should be made as an optimal choice in order to reach output growth sustainability in the long run. There are certain limitations of the approach. 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