WP/30/2018 
         WORKING PAPER  
         THE DETERMINANTS OF INDONESIAN BUSINESS 
         CYCLE 
         Berry A. Harahap 
         Pakasa Bary 
         Anggita Cinditya M. Kusuma 
          
          
         2018 
         This is a working paper, and hence it represents research in progress. This paper represents 
         the opinions of the authors, and is the product of professional research. It is not meant to 
         represent the position or opinions of the Bank Indonesia. Any errors are the fault of the authors 
                                                              
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                      THE DETERMINANTS OF INDONESIAN 
                                        BUSINESS CYCLE 
                                                        
                Berry A. Harahap, Pakasa Bary, Anggita Cinditya M. Kusuma 1 
               
                                                  Abstract 
               
              This study investigates the business cycle and financial cycle in Indonesia 
              after the economic crisis from the period 2000Q1 - 2018Q3 using several 
              approaches, including Turning Point Analysis, Frequency Based Filter, and 
              Composite Leading Indicator (CLI). In addition, this study also analyzes the 
              determinants of the business cycle through Global VAR (GVAR) with 2000 
              bootstrap replication.  Results  show that until the third quarter of 2018, 
              Indonesia's  business  and  financial  cycles  were  still  in  the  acceleration 
              phase. Likewise, the financial cycle that is still in an increasing/accelerated 
              pattern is driven by credit growth, which is still quite high. The acceleration 
              phase in the business cycle and the financial cycle of Indonesia in the last 
              few periods shows a more sloping recovery pattern or L-shaped recovery. 
              The  results  of  the  variance  decomposition  indicate  that  the  Indonesian 
              business cycle is influenced both by domestic factors and global factors. In 
              addition  to  exogenous  shock  from  output,  which  could  be  due  to 
              productivity,  the  dominant  domestic  factor  is  monetary  policy  and  price 
              competitiveness.  Meanwhile,  global  factors  that  predominantly  influence 
              Indonesia's business cycle are global economic activity and global liquidity 
              conditions.  The  variations  in  output  that  occur  in  China  are  the  most 
              important  for  Indonesia's  business  cycle.  Counterfactual  analysis  shows 
              that if China does not experience rebalancing, the acceleration phase of the 
              Indonesian business cycle will take place stronger with higher growth rates. 
              In  addition,  because  it  takes  into  account  indirect  global  relationships, 
              spillover analysis provides new findings that there are outputs of several 
              countries in Latin America that predominantly influence Indonesia's output.    
               
              Keywords: business cycle, financial cycle, turning point analysis, frequency-
              based filter, composite leading indicator, global vector autoregressive 
              JEL Classification: E32, F44, E30, C22 
               
               
               
                                                                         
              1  Senior  Economic  Researchers  and  Economic  Researchers  in  the  Department  of  Economic  and  Monetary 
              Policy (DKEM), Bank Indonesia. The views in this paper are the views of the author and do not reflect the 
              views of DKEM or Bank Indonesia. E-mail: berry@bi.go.id, pakasa@bi.go.id, and anggita_cmk@bi.go.id. 
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                  1.   Introduction 
                  1.1      Background 
                           A good understanding of the business cycle and financial cycle is important for policy 
                  makers in designing various policy programs, including for the central bank. Walsh (1999) 
                  explains that most central banks view that the contribution to a stable economy is one of their 
                  responsibilities. Promoting stable economic growth has important benefits, in that reducing 
                  the frequency or depth of recession is desirable to sustain a healthy business climate and open 
                  employment opportunities. Preventing expansion that avoids producing excessive inflation is 
                  also important because if inflation is too high, a high level of unemployment is needed to 
                  restore the economy to a stable level. 
                           Jimenez (2001) states that the business cycle could be very helpful for policy makers 
                  and  for  making  decisions  for  the  private  sector.  The  business  cycle  provides  a  tool  for 
                  estimating short-term economic behavior in the economy, for evaluating the outcomes of 
                  certain policy decisions in different markets, or for assessing the implementation of policies 
                  in  accordance  with  the  cycle  phase.  An  analysis  of  the  characteristics,  causes  and 
                  consequences of expansion and contraction is the main objective of business cycle theory. 
                           An understanding of the business and financial cycle is equally important for central 
                  banks in developing countries, including Bank Indonesia. The direction of policy issued by 
                  Bank Indonesia as a central bank is strongly influenced by economic conditions that are 
                  taking  place  in  Indonesia  or  future  economic  projections.  In  addition,  a  review  of  the 
                  condition of the business cycle and financial cycle is important to do in order to avoid the risk 
                  of a deep economic slowdown or vice versa so as not to hinder the period of expansion. On 
                  the other hand, the characteristics of Indonesia as a small, open economy contribute to the 
                  global economic conditions and various external factors to have a significant influence on the 
                  domestic cycle. This is coupled with the condition of the international financial market that is 
                  full of risk events which certainly affects Indonesia's vulnerability to external risks, which in 
                  turn could affect the domestic cycle. 
                           Such a notion is  consistent  with  the  opinion  that  the  determinants  of  a  country's 
                  business and financial cycles are closely related to the economic conditions in the country 
                  itself,  as  well  as  to  global  economic  conditions,  especially  for  small  and  open  countries. 
                  Garratt et al. (2011) stated that economic performance in the world is closely related through 
                  international trade and capital markets suggesting that fluctuations in the business cycle in a 
                  country are usually transmitted to other countries. 
                           Jimenez (2001) states that the external sector plays a key role in shaping small and 
                  open economic dynamics. In the context of business cycle analysis, the origin of the business 
                  cycle in developing countries could be understood as impulses originating from developed 
                  countries  that  condition  the  evolution  of  the  cycle,  especially  the  turning  point.  In  other 
                  words,  the  cycle  in  developing  countries  cannot  be  seen  as  a  pure  endogenous  process. 
                  International dimensions could affect small economies in two ways: first, through variation in 
                  relationships with major trading and financial partners, and second, through random events 
                  such as the oil crisis. For the business cycle analysis, the first variation is important because 
                  persistence occurs from time to time. 
                           Impulses coming from major trading and financial partners are usually distributed in 
                  small countries through two mechanisms of transmission, trade and financial channels. Trade 
                  channels  are  mainly  related  to  changes  in  small  country  exports  (demand  factors),  while 
                  financial  mechanisms  occur  through  variations  in  domestic  interest  rates  (cost  factors) 
                  because of changes in world interest rates. 
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                             Based on a good understanding of the conditions of the business and financial cycles 
                    is  very  necessary,  this  study  tries  to  analyze  the  conditions  of  Indonesia's  business  and 
                    financial  cycles  starting  from  the  post-Asian  economic  crisis  period  to  the  present.  In 
                    addition,  taking  into  account  that  Indonesia's  business  cycle  as  a  small-open  economy  is 
                    influenced by both domestic and global factors, this study at the same time attempts to look at 
                    the factors that are determinants of business cycle movements in Indonesia. By studying the 
                    business and financial cycle conditions and the determinants of business cycle movements in 
                    Indonesia, it is  hoped that policy makers could more accurately take policy responses to 
                    support the sustainability of Indonesia's economic growth. 
                    1.2      Research Questions 
                    Based on the background of the problems described earlier, the research questions are as 
                    follows:  
                    1.    What  is  the  condition  of  Indonesia's  business  and  financial  cycles  after  the  Asian 
                          economic crisis, which is precisely in the period Q1-2000 to Q3-2018?  
                    2.    What are the domestic and global factors set out to be the determinants of the Indonesian 
                          business cycle? 
                    1.3      Research Objectives 
                             The objectives of this study are as follows:  
                    1.    Analyzing the conditions of Indonesia's business and financial cycles after the Asian 
                          crisis,  i.e.,  in  the  period  Q1-2000  to  Q3-2018.  By  understanding  the  conditions  of 
                          Indonesia's business and financial cycles, policy makers could be expected to take more 
                          appropriate policy responses for both current and future policies.  
                    2.   Investigating factors that are determinants of the Indonesian business cycle, both global 
                          and domestic factors. By understanding the determinants of the business cycle both from 
                          global and domestic, it is expected that policy makers could anticipate economic turmoil 
                          in order to avoid deep recession and excessive economic expansion. 
                    1.4      Discussion Sections 
                             The presentation of this research is divided into five chapters. The first chapter is an 
                             introduction to the study that contains the background and questions and objectives of 
                             the study. The second chapter discusses literature studies and previous research that 
                             has been done. The third chapter describes the research methodology and the data. 
                             The  fourth  chapter  presents  the  findings.  Meanwhile,  the  fifth  chapter  provides 
                             conclusions and proposed policy recommendations. 
                     
                    2.   Literature Review 
                    2.1.     Business Cycle and Financial Cycle: An Overview 
                             A good understanding of the business cycle and financial cycle is important for policy 
                    makers in designing various policy programs. Jimenez (2001) states that the business cycle 
                    could be very helpful for policy makers and for making decisions for the private sector. The 
                    business cycle provides a tool for estimating short-term economic behavior in the economy, 
                    for evaluating the outcomes of certain policy decisions in different markets, or for assessing 
                    the  implementation  of  policies  in  accordance  with  the  cycle  phase.  An  analysis  of  the 
                    characteristics, causes, and consequences of expansion and contraction is the main objective 
                    of business cycle theory. 
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