Islamic Bank and Monetary Policy: The Case of Indonesia

Abstract

Islamic banks in Indonesia exist side by side with their conventional counterparts within a dual banking system. The central bank aims to achieve price stability in the economy using both conventional and Islamic monetary instruments within this dual monetary system. This creates a unique environment for Islamic banks. This research aims to examine the role of Islamic banks in the monetary policy transmission mechanism using Granger Causality and Autoregressive Distributed Lag (ARDL). The balance sheet components of deposit and financing are hypothesized to function in the monetary transmission process within the bank financing channel. Granger causality reveals that the Islamic interbank overnight rate Granger causes Islamic deposits and financing, and that these in turn Granger cause the industrial production index. This index Granger causes inflation, Islamic deposits, and the Islamic interbank overnight rate. Islamic deposits and inflation then Granger cause the Islamic interbank overnight rate. The ARDL results show cointegrating relationships in the output and inflation model. Long-term convergence could be achieved to correct deviations in output and inflation by way of Islamic banks’ deposits and financing. However, there is only a short-term influence of Islamic bank deposits on output. In the short-run, these deposits do not contribute to inflation. Islamic bank financing does not have a short-term relationship with output and inflation; therefore, there is declining effectiveness of Islamic banks’ financing contribution to the economy. Keywords: