Academic journal article IUP Journal of Applied Economics

Does Money Lead Prices in Malaysia? A Bivariate and Trivariate Analysis

Academic journal article IUP Journal of Applied Economics

Does Money Lead Prices in Malaysia? A Bivariate and Trivariate Analysis

Article excerpt

This paper reinvestigates the relationship between money supply and prices in Malaysia. The sample includes monthly data of money supply (M1, M2 and M3), Consumer Price Index (CPI) and Industrial Production Index (IPI) from January 1974 to April 2007. Both Johansen cointegration and Autoregressive Distributed Lag (ARDL) bounds testing method suggest that there is a long-run equilibrium relationship between money supply and prices in Malaysia. Toda-Yamamoto causality test results reveal that there is a unidirectional causality running from money supply to CPI, and this supports the quantity theorist's view, even when domestic real activity variable is included as a control variable.


This paper investigates the relationship between money supply and prices in Malaysia, using monthly data over the period January 1974-April 2007. Nowadays, empirical analysis on money and prices relationship has received greater attention, as there is a move to assign the single objective to the central bank. Among likely candidates of monetary policy objective, price stability is the single most important objective. Assignment of price stability as the single objective of monetary policy hinges on the empirical strength of money-Consumer Price Index (CPI) relationship. If empirical result shows a strong and robust relationship between money supply and CPI, then the central bank can opt for price stability as its single objective.

Over the past two decades, policy makers have become more aware of the social and economic cost of inflation and are more concerned with a stable price level as the goal of economic policy. Price stability is desirable because a rise in price level (inflation) creates uncertainty in the economy, and that may hamper the economy's growth. Not only do public opinion surveys indicate that the public is very hostile to inflation, but also a growing body of evidence suggests that inflation leads to lower economic growth (Fisher, 1993).

There is a strong positive correlation between changes in money supply and aggregate prices. Some studies have found a strong, if somewhat delayed, link between changes in the level of money supply and prices. Because of this, many economists like to keep an eye on changes in money supply since it may indicate changes in the rate of inflation later on (Clayton and Giesbrecht, 2001). The direction of causality, however, has long been a matter of controversy. The widely accepted quantity theory of money argues that inflation is caused by exogenous changes in the money supply. A minority 'structuralist' view holds that inflation develops from pressures arising from economic growth in economies with institutional rigidities, particularly in agriculture and international transactions. Monetary and fiscal authorities choose to expand the money supply, ratifying the inflationary pressures, rather than face unemployment or disruptions in consumption and investment. Underdeveloped financial markets and a weakly independent central bank can contribute to the likelihood of money supply growth. Under this view, money supply expansion is a consequence of, and therefore caused by, structural inflation (Pinga and Nelson, 2001).

The motivation of this study is the need for a further empirical work analyzing the relation between money supply and prices in Malaysia to reassert that causality exists. More technically, this research applies the Autoregressive Distributed Lag (ARDL) and Modified-Wald (MWald) test approach proposed by Toda and Yamamoto (1995), to reinvestigate the cointegration and causal relations between money supply and prices. This study has also accounted for the possible bias of using only bivariate framework in causality analysis as highlighted by Al-Yousif (1999), that bivariate framework is potentially misspecified and may be flawed due to the omission-ofvariable phenomenon. As a result, one would expect biased and mixed results of both causality and cointegration tests. …

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