Revisiting the Inflationary Impact of Fuel Subsidies: Insights from Indonesia’s Exposure to Global Oil Price and Exchange Rate Risks
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Exchange Rate, Fiscal Policy, Fuel Subsidy, Global Oil Prices, Inflation
Abstract
Research Originality — Existing studies on fuel subsidies and inflation largely focus on short-run effects or examine subsidy policies and external factors separately, with limited integration of global oil prices and exchange rates within a long-run framework, particularly in Indonesia. In addition, the transmission mechanisms through which fuel subsidy policies affect inflation remain insufficiently explored. This study addresses these gaps by conducting an integrated analysis of fuel subsidy policies and external macroeconomic pressures in both short- and long-run dynamics, while explicitly distinguishing between fuel subsidy expenditure and subsidized fuel prices as separate policy channels using a VECM approach.
Research Objectives — This study aims to analyze the influence of fuel subsidy policy on inflation and the differences in short-term adjustment dynamics and long-term equilibrium in the domestic price system in Indonesia.
Research Methods — This study utilizes a Vector Error Correction Model (VECM) using monthly data from 2006 to 2024. The study also incorporates various variables related to fuel subsidy allocation, subsidized fuel price, world oil price, rupiah/US dollar exchange rate, and Consumer Price Index (CPI). VECM is a model that can be used to check for long-run cointegration relationships between various variables. It also estimates the speed of adjustment to equilibrium in the short-run. Hence, VECM is an appropriate model for analyzing the dynamic relationship between various factors in determining inflation.
Empirical Results — The results of the present investigation revealed the presence of long-run cointegration among fuel subsidies, global oil prices, exchange rates, and inflation. It was revealed that in the long-run, an increase in world oil prices as well as the depreciation of the exchange rate have a positive impact on inflation. In the short run, it was revealed that an increase in the price of subsidized fuel has a positive impact on inflation. Furthermore, throughout the entire investigation period, it was revealed that inflation has a strong level of persistence.
Implications — The findings indicate the need for gradual fuel subsidy reforms in coordination with fiscal policy and exchange rate stabilization to minimize inflationary pressures and maintain household purchasing power amid global volatility. The study also contributes to the literature on fiscal and energy economics in developing countries by showing that the impact of subsidies needs to be understood within the framework of the dynamic interaction between energy pricing policies, external risks, and macroeconomic stability, rather than just being seen as a partial policy.
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