Regional Economic Structure and Heterogeneous Effects of Monetary Policy: Evidence From Indonesian Provinces

Abstract This paper investigates the reasons for heterogeneous monetary policy effects on inflation rate across 34 Indonesian provinces. We evaluate monetary transmission by combining monetary SVAR model with factor analysis (Bernanke et al., 2005). In the first part of analysis, we demonstrate the cross-sectional variation in regional inflation responses to monetary policy shock. Spatially, most provinces in the Java-Bali region have similar responses to the national response. Moreover, provinces with a higher share of manufacturing industries in Java and Sumatra island have a response that higher than average. In the second part, we examine the role of regional economic structure in affecting two constructed measurements of monetary policy effects on regional inflation, namely total impacts and efficiency. Consistent with the literature, we find that the impacts of monetary policy across regions are significantly influenced by the economic structure of regions, represented by four variables (manufacturing and mining share to GDP, bank lending to GDP ratio, and export to GDP ratio). In addition, we also find the significant role of manufacturing growth and spatial inflation externality in shaping monetary policy impacts on regional inflation. In a similar fashion, six regional structural variables are found statistically significant in explaining regional differences of monetary policy efficiency. Our findings imply the well-functioning of interest rate, bank lending and exchange rate channels of monetary policy on regional inflation in Indonesia.