INTERNATIONAL JOURNAL OF SCIENTIFIC & TECHNOLOGY RESEARCH VOLUME 8, ISSUE 12, DECEMBER 2019 ISSN 2277-8616 3595 IJSTR©2019 www.ijstr.org The Nexus Between Capital Flow, Welfare, And Financial Stability System: Evidence From Indonesia Yulia Indrawati, Munawar Ismail, Ghozali Maski, David Kaluge Abstract: This study aimed to analyze the function of the central bank’s objectives (welfare loss) by using four simulation policies, namely the Plain Vanilla Taylor rule, Lean against the wind Taylor rule, Independent Macroprudential policy rule and Lean against the wind Taylor rule with Macroprudential policy in small open economy model by including capital flow variable in model. Observation data used is the output, inflation, interest rates, credit growth, exchange rate and capital flow with the observation range 2006.1 - 2016.12. The initial value of parameter was obtained from Ordinary Least Square (OLS) estimation and previous empirical study. The optimal coefficient of simple rule is calculated using Dynare Optimal Simple Rule routine with dynare 4.5.7 and Mathlab software. The result of analysis show that Independent Macroprudential policy rule generating the most minimal value of loss function. More comprehensive modeling with the capital account in the model provides result of loss function is smaller. This suggests that macroprudential instruments as a buffer in monetary policy is optimal in minimizing the loss function of central bank. Central banks conduct monetary policy and macroprudential policy in an integrated manner for two different purposes. Interest rate policy aimed at achieving stability in inflation and output, while macroprudential policies for credit growth. The simulation results show the achievement Tinbergen Principle. Index Terms: Capital Flow, Loss Function, Monetary Policy, Macroprudential Policy. ——————————  —————————— 1. INTRODUCTION THE experience of the global financial crisis that occurred in 2008 provided important lessons in managing macroeconomic policies, especially attention in maintaining financial system stability. The global financial crisis in 2008 became a phase of global economic conjuncture decline again after the monetary crisis that occurred in mid-1997. Towards the end of the third quarter of 2008, the world economy was faced with a phase of global economic stability that was marked by the widening financial crisis to various countries since last month August 2007, when one of the largest French banks, BNP Paribas, announced the freezing of several securities related to high- risk housing loans in the United States (subprime mortgages). The freezing has implications for the emergence of turmoil in the financial markets and ultimately has a domino effect throughout the world. At the end of the third quarter of 2008, the intensity of the crisis was sharper with the bankruptcy of the largest investment bank in the United States namely Lehman Brothers, and was followed by financial difficulties in a number of large-scale financial institutions in the United States, Europe and Japan. According to [1] there are some lessons from the global financial crisis. First, there is a decline in real Gross Domestic Product (GDP) and high unemployment rates of countries experiencing crisis due to the financial crisis. Second, the magnitude of the cost of economic recovery after the crisis is marked by the large bail-out of financial institutions, fiscal stimulus and economic contraction resulting in a decrease in tax revenue and increased government debt. Third, the increased liquidity balance and the purchase of long-term assets that are exposed to interest rate risk and price fluctuations. Fourth, the achievement of price and output stability in fact does not guarantee financial system stability and there are broken lines in financial system regulation [2]. The phenomenon of the 2008 global financial crisis described as "once-in-a-hit-century credit tsunami" not only had an impact on the contraction of the world economy since the Great Depression, but also raised various questions about the effectiveness of policies, especially monetary policy, in achieving stabilization inflation and output. The global financial crisis shows that monetary policy is insufficient in maintaining overall financial stability. Low inflation and output volatility drives low economic players' expectations of risk, making the financial system more vulnerable to crisis. According to [3] that the crisis was caused by the policy of the central bank in maintaining interest rates that are too low due to low levels of inflation in a fairly long period before the crisis without taking into account the risks in the banking and financial sectors in the monetary policy reaction function. The results of the same study show [4], [5], and [3] that the case of "leaning against the wind" through the use of interest rate instruments in achieving price and output stabilization has implications for the emergence of risks to credit growth and asset prices. [6] states that low interest rates will increase the incentives of business people to look for assets with excess income and high risk. While the [7] shows that when the economy is in good condition it makes the financial system more vulnerable due to excessive risk taking. Monetary stability encourages speculative actions of financial actors in seeking higher profits and increasing leverage when interest rates are low and creating moral hazard from market participants against macroeconomic risks [8]. This is due to expectations that are too high for the economy to come, thereby pushing the risk of excessive credit growth and creating asset price bubbles. Related to the asset price bubble, [1] stated that there is an important debate about lean versus clean monetary policy responses to the asset price bubble. Meanwhile according to [9] it is difficult to distinguish the types of asset price bubbles, because not all asset price bubbles are the same. There are two types of asset price bubbles, namely the credit-driven bubble as happened in the 2008 crisis which is considered ————————————————  Author: Doctoral Programme of Economics, Faculty of Economics and Business, Universitas Brawijaya, Indonesia. Corresponding Author’s Email: yuliaindrawati2012@gmail.com  Co-Author: Faculty of Economics and Business, Universitas Brawijaya, Indonesia. E-mail: mismail@ub.ac.id, ghozalimaski@ub.ac.id, davidk@ub.ac.id