Academic journal article The Journal of Developing Areas

Monetary Policy for Maintaining Low, Stable Inflation in Malaysia

Academic journal article The Journal of Developing Areas

Monetary Policy for Maintaining Low, Stable Inflation in Malaysia

Article excerpt

(ProQuest: ... denotes formulae omitted.)


In an open-economy, price stability (i.e. low, stable inflation) plays a key role in maintaining macroeconomic stability. Macroeconomic stability promotes technological innovation, productive investment and hence raises economic growth (Fischer, 1993; Montiel, 2003). Analytically, exchange rate policy has moved to the center stage of macroeconomic policy because, under the open-economy trilemma condition,1 exchange rate policy has implications for macroeconomic stability and performance, including inflation and its stability. Exchange rate policy has indeed become important for an outward-oriented developing country such as Malaysia (Athukorala and Menon, 1999; Hossain, 2015a, 2015b).

Malaysia has sustained rapid but unsteady economic growth in the midst of moderately high and volatile inflation for most of the time since its independence in 1957. Until 2005, Malaysia operated under a fixed-pegged exchange rate system and maintained control over capital flows. Informally, until the 1990s, the Bank Negara Malaysia (BNM)2 employed a soft form of monetary targeting for internal use only. As this was not taken seriously by economic stakeholders, monetary policy credibility was low and the growth rate of the money supply remained moderately high and volatile. Consequently, under mild financial repression that included both a fixed-pegged exchange rate system and control over interest rates and capital flows, inflation became volatile in the midst of shocks of both domestic and foreign origin.3 High inflation volatility spilled over into the real interest and exchange rates, which raised outputgrowth volatility and made the economy vulnerable to boom-bust cycles (Hossain, 2015a, 2015b).4

Overall, because Malaysia accorded a high priority to economic growth, price stability was de facto relegated to the secondary place. Therefore, the conduct of monetary policy in this country remained ad hoc within a growth-oriented macroeconomic policy paradigm. Within this paradigm, the monetary authorities neither defined price stability nor formalized a money-based monetary policy to maintain price stability. Furthermore, contrary to any best practice monetary policy since the Asian financial crisis of the late 1990s, both exchange rate stability and economic growth have remained in the list of monetary policy objectives, although it is not clear how monetary policy can be employed to achieve multiple objectives simultaneously without creating any conflicts and tradeoffs.

As part of determining the appropriate strategy of monetary policy for price stability, the paper investigates some monetary relations-namely the stability of the money-demand function and the linkages among money, output and prices-which form the foundation of a money-based monetary policy strategy for price stability under a flexible exchange rate system.5 The empirical results suggest that the narrow moneydemand function in Malaysia remained stable over the period 1971-2012 and that cointegral-causal linkages existed in this country among money, output and prices throughout this period. These results give credence to deployment of monetary aggregates as an instrument of monetary policy, especially when the flexibility, effectiveness of a zero-bound interest rate remains doubtful as an instrument of monetary policy in a low-inflation environment.

The remainder of this paper is organized as follows: Section 2 reviews the dynamic behavior of inflation in Malaysia since the 1950s. Section 3 provides an overview of monetary policy strategy in Malaysia since the 1970s. Section 4 investigates some monetary relations for Malaysia as part of an investigation of the possibility of introducing a money-based monetary policy. Section 5 examines both the interest-based and money-based transmission mechanisms of monetary policy to determine whether a rule-based monetary policy could be effective in maintaining price stability. …

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