Money velocity, digital currency and inflation dynamics in Indonesia

Danny Hermawan, Denny Lie, Aryo Sasongko and Richard I. Yusan

Bulletin of Indonesian Economic Studies, 2024, vol. 60, issue 3, 305-345

Abstract: This paper empirically investigates the impact of transaction–cost-induced variations in the velocity of money on inflation dynamics in Indonesia, using a structural New Keynesian Phillips curve incorporating an explicit money-velocity term. The effect of money velocity arises from the role of money, both physical and digital, in reducing aggregate transaction costs and facilitating the purchase of goods and services. We find a non-trivial aggregate impact on the Indonesian economy: our benchmark estimates suggest that a 10% decrease in money velocity due to the issuance of a new digital currency (for example, a central bank digital currency [CBDC]), would reduce the inflation rate by 0.6%–1.7%, all else being equal. We show that shocks to the velocity of money are an important driver of aggregate fluctuations by incorporating these estimates into a small-scale New Keynesian dynamic stochastic general equilibrium model calibrated to the Indonesian economy. The model’s simulation shows that a CBDC issuance equivalent to about 5% of nominal GDP in Indonesia in 2023 would permanently increase real GDP by almost 1% and lower the inflation rate by nearly 1%. Both nominal and real interest rates would also be permanently lower. Our findings suggest that central banks could use CBDCs as an additional tool for stabilisation policy by influencing money velocity.

Date: 2024
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DOI: 10.1080/00074918.2024.2398347

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