How Malaysia Government Can Reduce Inflation Rate by Using Monetary and Fiscal Policy
Are monetary disturbances and fiscal deficits inflationary? Empirical evidence from Malaysia
Associate Professor Dr Tan Juat Hong College of Graduate Studies, Universiti Tenaga Nasional, Malaysia
ABSTRACT: The study uses the VAR model to investigate the responses of domestic inflation to monetary and fiscal policies, with output as the scale variable. The results show that domestic inflation responds positively to monetary policy shocks but not to fiscal deficits. If one assumes the velocity of money as constant, then it underscores that inflation is a monetary phenomenon and excessive money supply spawns inflation. Thus, monetary policy constitutes a more pertinent macroeconomic instrument to control spiralling inflation.
1. INTRODUCTION
Malaysia’s economic performance was impressive in the late 1980s as well as the early 1990s with a real growth averaging 8% per annum. This sustained economic growth phenomenon was primarily due to expansionary monetary and fiscal policies, compounded by an influx of foreign direct investment (FDI). However, growth halted when the Malaysian economy succumbed to the financial crisis of 1997/98 and faced adverse economic consequences where real output growth dipped to negative growth of minus 4% in 1998, coupled with a fast depreciating domestic currency and liquidity crunch. To circumvent the problems, the Malaysia government fixed the exchange rate of the Ringgit against the US dollar (US$1 = RM3.80) in a bid to stabilise the domestic currency; while the capital controls policy was enforced to curb a severe liquidity crunch. These stabilisation measures were effective as they lifted the real output growth for the Malaysian economy hovering moderately at 5% - 6% annually post-1998. However, in July 2005 these stringent economic policies were abolished and the domestic currency was floated again. Notwithstanding the oil price spikes reaching its zenith at US$147 per barrel in 2007, the Malaysian economy achieved a remarkable real
Associate Professor Dr Tan Juat Hong College of Graduate Studies, Universiti Tenaga Nasional, Malaysia
ABSTRACT: The study uses the VAR model to investigate the responses of domestic inflation to monetary and fiscal policies, with output as the scale variable. The results show that domestic inflation responds positively to monetary policy shocks but not to fiscal deficits. If one assumes the velocity of money as constant, then it underscores that inflation is a monetary phenomenon and excessive money supply spawns inflation. Thus, monetary policy constitutes a more pertinent macroeconomic instrument to control spiralling inflation.
1. INTRODUCTION
Malaysia’s economic performance was impressive in the late 1980s as well as the early 1990s with a real growth averaging 8% per annum. This sustained economic growth phenomenon was primarily due to expansionary monetary and fiscal policies, compounded by an influx of foreign direct investment (FDI). However, growth halted when the Malaysian economy succumbed to the financial crisis of 1997/98 and faced adverse economic consequences where real output growth dipped to negative growth of minus 4% in 1998, coupled with a fast depreciating domestic currency and liquidity crunch. To circumvent the problems, the Malaysia government fixed the exchange rate of the Ringgit against the US dollar (US$1 = RM3.80) in a bid to stabilise the domestic currency; while the capital controls policy was enforced to curb a severe liquidity crunch. These stabilisation measures were effective as they lifted the real output growth for the Malaysian economy hovering moderately at 5% - 6% annually post-1998. However, in July 2005 these stringent economic policies were abolished and the domestic currency was floated again. Notwithstanding the oil price spikes reaching its zenith at US$147 per barrel in 2007, the Malaysian economy achieved a remarkable real
References: Kandil, Magda (2006). The growth of government spending and the money supply: Evidence and implications within and across industrial countries. Journal of Economic Studies, 33: 406-436 Komulainen, Tuomas and Jukka Pirttila (2002). Fiscal explanations for inflation: Any evidence from transition economies? Economics of Planning, 35: 293-316 Lombardo, Giovanni and Alan Sutherland (2004). Monetary and fiscal interactions in open economies. Journal of Macroeconomics, 26:319-347 Saini, Krishnan G. (1982). The monetarist explanation of inflation: The experience of six Asian countries. World Development, 10: 871-884 Sargent, Thomas J. (1999). A primer on monetary and fiscal policy. Journal of Banking and Finance, 23, 1463-1482 Siregar, Reza and Gulasekaran Rajaguru (2005). Sources of variations between the inflation rates of Korea, Thailand and Indonesia during the post-1997 crises. Journal of Policy Modeling, 27: 867-884 Tan, Juat Hong (2006). Monetary policy and macroeconomic shocks in Malaysia: Evidence from the aggregate demand-aggregate supply model. Banker’s Journal Malaysia, 130: 36-43 Us, Vuslat (2004). Inflation dynamics and monetary policy strategy: Some prospects for the Turkish economy. Journal of Policy Modeling, 26: 1003-1013 Woodford, Michael (2001). Fiscal requirements for price stability. Journal of Money, Credit and Banking, 33: 669-729 7. SUMMARY AND CONCLUSIONS The study investigates the responses of domestic inflation to monetary and fiscal innovations. These interactions are analysed by using the vector autoregression (VAR) models with domestic inflation, monetary and fiscal policies as endogenous variables and Gross Domestic Product (GDP) gap as the exogenous variable. The study focuses on the transmission of monetary shocks and fiscal deficits to domestic inflation through the impulse response functions and variance decomposition. The results from the impulse response functions and variance decomposition indicate that monetary shocks exert a positive and greater impact on domestic inflation. In short, domestic inflation stems mainly from monetary policy disturbances. The study finds no evidence of a pass-through inflation from budget deficits. 17