European Journal of Economics, Finance and Administrative Sciences

ISSN 1450-2275 Issue 24 (2010)
© EuroJournals, Inc. 2010
http://www.eurojournals.com

Determinant Factors of Economic Growth in
Malaysia: Multivariate Cointegration and Causality Analysis


Mori Kogid
Corresponding Author School of Business and Economics
Universiti Malaysia Sabah, Sabah, Malaysia
E-mail: morikogid@gmail.com
Tel: (+6088) 320000 Ext. 1627; Fax: (+6088) 320360

Dullah Mulok
School of Business and Economics, Universiti Malaysia Sabah, Sabah, Malaysia

Lim Fui Yee Beatrice
School of Business and Economics, Universiti Malaysia Sabah, Sabah, Malaysia

Kasim Mansur
School of Business and Economics, Universiti Malaysia Sabah, Sabah, Malaysia


Abstract
This paper investigates the factors that stimulate and maintain economic growth. The
determinant factors studied are consumption expenditure, government expenditure, export,
exchange rate, and foreign direct investment in Malaysia from the year 1970 to 2007. This
study uses cointegration analysis and the causality approach by Johansen and ECM to
analyze the relationship between economic growth and the determinant factors. The results
of this study show that there exists long-run cointegration and multiple short-run causal
relationships between economic growth and the determinant factors. Overall, findings show
that all the determinant factors (combined determinant factors) cause economic growth in
the short-run. However, individual tests indicate that only consumption expenditure and
export cause economic growth while this is not so for the government expenditure,
exchange rate and foreign direct investment. The study concludes that consumption
expenditure and export play important roles as determinant factors to economic growth,
and government expenditure, exchange rate and foreign direct investment may have a role
as a catalyst and complement determinant factors to economic growth in Malaysia.


Keywords: Economic growth, Determinant factors, Cointegration, Causality, Malaysia

1. Introduction
The paradigm shift in the economy from static to dynamic has sparked considerable attention from
economists since the 90s. The idea is that economy is not static – economic structure can change
(Galbraith, 1994). A change in the economy can affect the development of a country. For this reason,
economic growth and the factors leading to growth has been a constant area of study.
Traditional growth theory based on Solow (1956) and Denison (1962) as cited in Piazolo
(1996) shows that setting the output depends on the level of capital stock, the volume of labour
124 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

employed and types of technology. Factors like savings and investment rate or the institutional
framework (e.g. government consumption expenditure) are also cited as minor influences for long term
economic development. The new growth theory on the other hand focuses mainly on (i) technological
change, (ii) the role of the government, (iii) trade policy, and (iv) human capital development as
determinants of economic growth (Piazolo, 1996).
Past studies (Baro, 1996a; Alfaro, Chanda, Kalemli-Ozcan and Sayek, 2004; Cortes-Jimenez
and Pulina, 2006) use a lot of analysis based on cross-country data or include import as well as export
variables (Jung and Marshall, 1985; Chow, 1987; Thirlwall, 1994; Ahmad and Harnhirun, 1996;
Balaguer and Jorda, 2001; Awokuse, 2002; Sharma and Panagiotidis, 2005; Cortes-Jimenez and
Pulina, 2006) in explaining the relationship between economic growth and determinant factors. Some
of the cited factors are: consumption expenditure, government expenditure, investment and import-
export. Most literature however focus more on export factor as a determinant to output growth (Chow,
1987; Thirlwall, 1994; Ahmad and Harnhirun, 1996; Balaguer and Jorda, 2001).
The main objective of this study is to investigate the relationship and causal pattern of several
determinant factors (consumption expenditure, government expenditure, export, exchange rate, and
foreign direct investment) towards economic growth in Malaysia. In addition, this study will also look
into the possible effects of combined determinant factors towards economic growth.


2. Selected Literature Review
There is a vast amount of research in the area of economic growth. Both theoretical (Ricardo, 1817;
Jung and Marshall, 1985; Mankiw, Weil and Romer, 1992; Galbraith, 1994; Krugman, 1994;
Thirlwall, 1994; Young, 1995; Baro and Sala-i-Martin, 1995; Baro, 1996a & 1996b; Klenow and
Rodriguez-Clare, 1997; Easterly and Levine, 1999; Chen, 2009) and empirical studies (Jung and
Marshall, 1985; Benhabib and Spiegel, 1994; Ahmad and Harnhirun, 1996; Piazolo, 1996; Ramirez,
Ranis and Stewart, 1998; Bebczuk, 2000; Balaguer and Jorda, 2001; Khalafalla and Webb, 2001;
Awokuse, 2002; Alfaro, Chanda, Kalemli-Ozcan and Sayek, 2004; Li and Liu, 2005; Sharma and
Panagiotidis, 2005; Yoo, 2006; Hsiao and Hsiao, 2006; Baharumshah and Thanoon, 2006; Sinha and
Sinha, 2007; Agu and Chukwu, 2008; Chakraborty and Nunnenkamp, 2008; Sook-Ching, Kogid and
Furuoka, 2010) have been carried out in order to determine contributing factors to economic growth.
Research has also been carried out using the Malaysian and Asian context (Young, 1995; Ahmad and
Harnhirun, 1996; Khalafalla and Webb, 2001; Tang, 2003; Yoo, 2006; Baharumshah and Thanoon,
2006; Ang, 2008; and Sook-Ching, Kogid and Furuoka, 2010). The multitude of research also shows a
variety of data analysis techniques. The data analysis technique used in this study follows closely to
studies done by Ahmad and Harnhirun (1996), Awokuse (2002), Sharma and Panagiotidis (2005), and
Sook-Ching, Kogid and Furuoka (2010).
According to Chow (1987), the contribution of export growth to the development of countries
can be measured through its impact on the increase of the country’s income, production of non-export
goods, capital efficiency and its ability in handling external shocks, negative external effects, resource
allocation and also total productivity factor. As stated above, ‘export’ is the most researched
determinant factor for economic growth, perhaps for the reason that since the 1970s, most developing
countries have practiced export promotion. Research supports export as an effective component of
economic growth in developing countries. Furthermore, these countries have also testified to export
promotion as an effective development strategy (Jung and Marshall, 1985).
However, export is not the main contributing factor towards economic growth. Studies have
found that a number of other determinant factors contribute to economic growth. Ahmad and
Harnhirun (1996) studied the economic success of new industrial countries such as Indonesia,
Malaysia, Philippines, Singapore and Thailand using time data series from the year 1966 until 1988 to
find out whether export is the cause of the countries’ economic growth. They found that the link
between export and economic growth lies in the development policy. Interestingly, their studies also
125 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

found that it is economic development that causes export growth, and not vice versa. Studies by
Balaguer and Jorda (2001) found that although export is a definite cause of economic growth during
economic liberalization in Spain, there are other indirect causes from output growth to export.
However, according to Awokuse (2002), the identification of empirical evidence linking export
to economic growth is variegated. He re-tested the export-lead growth hypothesis for Canada using the
Granger causality test from export to output growth using the Vector Error Correction Model (VECM)
and an augmented Vector Autoregression (VAR) method developed by Toda and Yamamoto. The
result of the study found that a long-term relationship exists in the model with six variables and there is
a flow of Granger cause from real export to real GDP. Sharma and Panagiotidis (2005) reinvestigated
economic growth sources in India for the periods 1971 to 2001. They developed the Feder model to
empirically investigate the relationship between export growth and GDP growth using data from the
Reserve Bank in India. They gave particular attention to GDP growth and net GDP growth on export.
However, they failed to prove the argument that export was the Granger cause to GDP based on the
Engle-Granger and Johansen approach (using two measurements namely GDP with export and GDP
without export).
Cortes-Jimenez and Pulina (2006) explored the effects of foreign exchange, specifically tourism
on economic growth. Their study found that international tourism is the largest foreign exchange
earner for most low-income countries, as is with developed countries. Currently, many developing
countries are giving pressure to economic policies to promote international tourism as a potential
contributing factor to a nation’s economic growth. However, efforts to gain greater understanding on
the relationship between export and economic growth are still continued. It appears that cross-section
studies support the hypothesis that export is inclined to spur economic growth, while time series
studies do not. Cortes-Jimenez et al. (2006) also tried to study whether export and tourism which are
export-lead growth hypothesis and growth-lead tourism, really do encourage economic growth. The
outcome of their research on Spain and Italy using the cointegration and multiple Granger causality test
showed that export is the cause to economic growth in the long run for both countries, while tourism is
the more influencing factor to economic growth in the long run for Spain.
Ricardo (1817) argues that the wealth of a country that is involved in trading will increase
compared to countries that do not trade (Khalafalla and Webb 2001). Considering its impact on
economic growth, foreign trade development is a factor of constant discussion. The existence of
foreign trade and development is closely linked to economic growth where foreign trade encourages
economic growth to a country (Chen 2009). Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004)
attempted to identify various relationships between Foreign Direct Investment (FDI), financial market
and economic growth. They also sought to find out whether countries with better financial systems are
able to exploit FDI more efficiently. Their empirical analysis used cross country data between the years
1975 to 1995. The study found that with 71 countries, FDI played an ambiguous role in contributing to
economic growth. On the other hand, countries with a structurally good financial market were able to
gain significant advantages from FDI. Li and Liu (2005) studied whether FDI affected economic
growth based on panel data for 84 countries from the year 1970 to 1999. Single and simultaneous
systems of equation techniques were used to test this relationship. Their research found a significant
relationship between FDI and economic growth which was identified from the mid 1980s and after.
FDI appears to indirectly interact with human capital, which leads to a strong positive effect on
economic growth in developing countries. It should be noted that in countries with a technological gap,
FDI gives a significant negative impact on economic growth.
The study by Hsiao and Hsiao (2006) employed panel data and time series from 1986 to 2004
to identify the link in Granger causality between GDP, export and FDI among China, Korea, Taiwan,
Hong Kong, Singapore, Malaysia, Philippines and Thailand. (These are considered fast developing
countries in South East Asia and East Asia.) The result of their research found that FDI has a direct
one-way effect on GDP and an indirect effect through export. There was also a bilateral causal
relationship between export and GDP. In addition, panel data causal analysis has a stronger decision
126 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

outcome compared to time series causal analysis. In another study conducted by Baharumshah and
Thanoon (2006), a quantitative assessment was carried out on various types of flow models towards the
growth process in East Asian countries including China. Their empirical findings based on dynamic
data panel showed positive domestic savings contributed to economic growth in the long run. Their
study confirms that FDI causes growth and its effects can be experienced in both short and long-term.
A major discovery of their study is that FDI contributes largely to the development of East Asian
economy and suggests that the countries which succeed in attracting FDI inflow can generate more
investment, leading to faster overall development. Ang (2007) used annual time series data from 1960
to 2005 in his study to see the determinants of FDI for Malaysia. His study found that real GDP had a
significant positive impact on FDI inflow. There was also evidence that the GDP growth rate gave a
minor positive impact on FDI inflow.
A number of previous studies have focused on the effect of education investment (see Mankiw
et al., 1992; Benhabib and Spiegel, 1994; Barro and Sala-i-Martin, 1995; Barro, 1996a & 1996b and
Ramirez et al., 1998), bank financing (Tang, 2003), financial deepening (Agu and Chukwu, 2008),
saving (Sinha and Sinha, 2007), electricity (Yoo, 2006) and insurance (Sook-Ching et al., 2010) as
additional factors on the economic growth of a nation Piazolo (1996) studied the determinants of
Indonesian economic growth through time series analysis based on cointegration and error correction
model from the year 1965 to 1992. He showed that the determinants of economic growth in Indonesia
were human capital, investment, government consumption, imports and inflation especially in the long
term. Exports played a strong positive influence on Indonesian economic growth in the short term.
Trade and financial liberalization as well as exogenous technological change also contributes positively
to economic growth. The inter-relationship between human capital and economic growth has been
discussed at length in previous studies. Ramirez et al. (1998) found that high level human capital
development can affect the economy through the population’s increase in capacity, productivity and
creativity. Investment in education will promote the development of a critical and technologically
skilled human capital.
Tang (2003) in his study re-investigated the role of bank financing as an alternative factor on
Malaysian economic development by using the bounds testing approach. The study covered the annual
periods from 1960 to 1998. The study found that there was no long term relationship between the
volume of bank lending and the real Gross Domestic Product (GDP). The study also found that bank
lending is influenced by the country’s economic growth in the long-run. Agu and Chukwu (2008) made
a study on the causal direction between “bank based” financial deepening variables and economic
growth in Nigeria between the years 1970 to 2005 using the augmented Granger causality test. The
result of the cointegration test showed that financial deepening and economic growth cointegrate
positively. The result of their study also suggests that the selection pattern to the financial deepening
variable influenced the causal result.
Meanwhile, Sinha and Sinha (2007) studied the relationship between per capita saving and per
capita GDP in India using the Granger causality test based on the Toda and Yamamoto approach. The
data used were from 1950 to 2004. The types of savings include household, corporate and public
savings. The result of their studies showed that there are no causal relationships between per capita
GDP with per capita household savings or per capita corporate savings coming from any direction.
However, there exist a bilateral causal relationship between per capita household savings and per capita
corporate savings.
Yoo (2006) tried to see the causal relationship between electricity usage and economic growth
amongst four ASEAN countries namely Indonesia, Malaysia, Singapore and Thailand using modern
time series data for the years 1971 to 2002. They found that there is a bilateral causal relationship
between electricity use and economic growth in Malaysia and Singapore, while a one-way causal
relationship exists towards economic growth through electricity usage in Indonesia and Thailand.
There are also studies on the relationship between the life insurance sector and economic
growth. For instance, study done by Sook-Ching, Kogid and Furuoka in 2010 applies the Johansen co-
127 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

integration test, and the Granger causality test based on the Vector Error Correction Model (VECM) to
examine the causal relation between the life insurance and economic growth in Malaysia using
quarterly data from 1997 to the second quarter of 2008. They found that, there is sufficient evidence to
support a long-run relationship between the life insurance and the real GDP, and also a short-run causal
relation from the real GDP to the life insurance.


3. Data and Methodology
All annual time series data (subject to data availability and time periods) which are Gross Domestic
Product at current price (GDP), Consumption Expenditure (CE), Government Expenditure (GE),
Export (X), Exchange Rate (ER) and inflow Foreign Direct Investment (FDI) from the periods 1970 to
2007 in this study were obtained from International Financial Statistics (IFS), Department of Statistics
Malaysia, Central Bank of Malaysia and United Nations Conference on Trade and Development
(UNCTAD). All data was transformed to logarithmic form. This research applied the Johansen
approach for multivariate cointegration analysis and the Error Correction Model (ECM) approach for
multivariate and bivariate causality analysis.
Generally, we only have limited knowledge about the economic processes that determine the
observed data. Thus, while models involving such data are formulated by economic theory and then
tested using econometrics techniques, it has to be recognized that theory in itself is not enough. For
instance, theory may provide little evidence about the processes of adjustment, which variables are
exogenous and indeed which are irrelevant or constant for the particular model under investigation
(Hendry, Pagan and Sargan, 1984). A contrasting approach is based on statistical theory, which
involves trying to characterize the statistical processes whereby the data were generated.
To begin with, the functional exact relationship between the dependent variable and
independent variables in logarithmic form (L) where y
t
is a function of x
it
can be specified using
mathematical expression as follows:
( )
t it
y f x = (1)
or in a linear form:
0 t i it
y x α β = + (2)
where y
t
= LGDP at time t, x
it
= LCE, LGE, LX, LER and LFDI at time t, i = 1, 2, 3, …, n, and where
0
α and
i
β are unknown parameters of the model. The purely mathematical model of the economic
growth function given in equation (2) is of limited interest to the most researchers, for it assumes that
there is an exact or deterministic relationship between CE, GE, X, ER, FDI, and GDP. But
relationships between economic variables are generally inexact because, in addition to CE, GE, X, ER
and FDI, other variables may affect economic growth. Thus, to allow for the inexact relationship
between economic variables, this can be modifying the deterministic economic growth function as
follows:
0 t i it
y x α β ε = + + (3)
where , ε known as the disturbance, or error term, is a random (stochastic) variable that has well-
defined probabilistic properties. The disturbance term ε may well represent all those factors that affect
economic growth but are not taken into account explicitly.
Many economic and financial time series exhibit trending behaviour or nonstationarity in the
mean. According to Nelson and Plosser (1982), most time series macroeconomic data contain unit root
which are caused by a stochastic trend even though in some situation the trend follow random walk
process. A unit root test is important to determine whether a data series is stationary or not. This is
because estimators which are not stationary in most empirical research produce void results. A unit
root test was conducted using Dickey-Fuller (DF) or Augmented Dickey-Fuller (ADF), Phillips-Perron
(PP), Kwiatkowski-Phillips-Schmidt-Shin (KPSS), and Ng-Perron (NP) tests. Generally, DF and ADF
test (Dickey and Fuller, 1979) can be show as follow:
128 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

0 1 t t t
y y α δ ε

∆ = + +
(4)
where ∆ is the first difference operation,
t
ε is stationary random error and
t
y is LGDP
t
, LCE
t
, LGE
t
,
LX
t
, LER
t
or LFDI
t
. The null hypothesis for this test is 0 = δ . If the null hypothesis 0 = δ cannot be
rejected, then the data set for
t
y contains unit root (not stationary).
0 1 1
2
p
t t i t i t
i
y y y α δ β ε
− − +
=
∆ = + + ∆ +

(5)
where p is autoregressive level that is AR(p) which is suitably selected based on the smallest Schwarz
Information Criterion (SIC) value. The hypothesis 0 = δ will be rejected if δ is significant (negative).
While the equation for SIC is shown as follows:
log( )
2
l T
SIC k
T T
 
= − +
 
 
(6)
where l is the value of the log of the likelihood function with the k parameters estimated using T
observations. The various information criteria are all based on -2 times the average log likelihood
function, adjusted by a penalty function.
An alternative approach is the Phillips-Perron (PP) method (Phillips and Perron, 1988). Rather
than taking account of the extra terms in the data-generating process (d.g.p) by adding them to the
regression model (as in ADF test), a non-parametric correction to the t-test statistic is under-taken to
account for autocorrelation that will be present when the underlying d.g.p. is not autoregressive at first
level, AR(1). Phillips and Perron (1988) propose an alternative (non-parametric) method of controlling
for serial correlation when testing for a unit root. The PP method estimates the non-augmented Dickey-
Fuller (DF) test equation (4), and modified the t-ratio of the δ coefficient so that serial correlation does
not affect the asymptotic distribution of the test statistic. The PP test procedure (a generalization of the
ADF test procedure) is based on the following regression
1 0 1 t t t
y y α δ ε
− −
∆ = + +
(7)
and the statistic:
1 2
0 0 0
1 2
0 0
ˆ ( )( ( ))
2
T f se
t t
f f s
α α
γ γ α   −
= −
 
 
%
(8)
where ˆ α is the estimate, and t
α
the t-ratio of α , ˆ ( ) se α is coefficient standard error, and s is the
standard error of the test regression. In addition,
0
γ is a consistent estimate of the error variance in
equation (1) calculated as
2
( ) / T k s T − , where k is the number of regressors. The remaining term,
0
f ,
is an estimator of the residual spectrum at frequency zero.
The third unit root test, the KPSS test proposed by Kwiatkowski, Phillips, Schmidt and Shin in
1992 differs from the other unit root tests in that the series
t
y is assumed to be stationary under the null
hypothesis. However, this test is seen to be useful for confirmatory analysis (to confirm the conclusion
about unit roots) rather than its role as a sole unit root test. The KPSS test statistic is the Lagrange
Multiplier (LM) and based on the residuals from the OLS regression of
t
y on the exogenous variable
t
x .
'
t t t
y x δ ε = +
(9)
The LM statistic is defined as:
2 2
0
( ) /( )
t
LM S t T f =

(10)
where
0
f is an estimator of the residual spectrum at frequency zero and where ( ) S t is a cumulative
residual function:
1
ˆ ( )
t
r
r
S t u
=
=

(11)
129 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

based on the residual
ˆ
ˆ ' (0)
t t t
u y x δ = −
.
Although, the ADF and PP tests are routine and widely used in testing for unit roots in most
time series macroeconomic data, these tests are considered to have several problems, particularly in
terms of their low power and size distortions. Schwert (1989) finds that if ∆y
t
has an ARMA
representation with a large and negative MA component, then the ADF and PP tests are severely size
distorted (reject I(1) null much too often when it is true) and that the PP tests are more size distorted
than the ADF tests. Caner and Killian (2001) have found similar problems with the KPSS test.
Recently, Perron and Ng (1996) have suggested useful modifications to the PP tests to mitigate this
size distortion.
The more robust and efficient unit root test, NP test was proposed by Ng and Perron in 2001.
Ng and Perron (2001) use the GLS detrending procedure of ERS (Elliot, Rothenberg and Stock, 1996)
to create efficient versions of the modified PP tests of Perron and Ng (1996). These efficient modified
PP tests do not exhibit the severe size distortions of the PP tests for errors with large negative MA or
AR roots, and they can have substantially higher power than the PP tests especially when δ is close to
unity. Ng and Perron (2001) constructed test statistics that are based upon the Generalized Least
Squared (GLS) detrended data y
t
.
Using the GLS detrended data
d
t
y , the efficient modified PP tests are defined as
1
1 2 2
1
1
ˆ
( ) 2
T
d d
t t
t
MZ T y T y
α
λ

− −

=
 
= −
 
 

(12)
1 2
2 2
1
1
ˆ
/
T
d
t
t
MSB T y λ


=
 
=
 
 

(13)
t
MZ MZ MSB
α
= ×
(14)
The statistics MZ
α
and MZ
t
are efficient versions of the PP Z
α
and Z
t
tests that have much
smaller size distortions in the presence of negative moving average errors. Ng and Perron (2001) also
stress that good size and power properties of the all the efficient unit root tests rely on the proper
choice of the lag length, p. They argue, however, that traditional model selection criteria such as AIC
are not well suited for determining p with integrated data. Ng and Perron (2001) suggested the
Modified Akaike Information Criteria (MAIC) instead of AIC in determining the lag length p by
minimizing the value of MAIC.
This study then used the Johansen approach to test the movement of the variables in the long-
run. Only variables of the same integration level are taken into account in testing for the presence of
cointegration. Johansen’s cointegration test is based on the maximum likelihood estimation towards k-
dimensional vector autoregression (VAR) at level p,
1 1 2 2 1 1 1
...
t t t k t p t t
Z Z Z Z Z µ π ε
− − + − + −
∆ = + Γ ∆ + Γ ∆ + Γ ∆ + +
(15)
where Z
t
is k x 1 stochastic variable vector, µ is k x 1 constant vector,
t
ε is k x 1 random vector, π
and
1 1
.......
+
Γ Γ
k
is k x k parameter matrix. Meanwhile, if the coefficient matrix π has reduced level, r <
k, therefore the matrix can be simplified to '. αβ π = The Johansen test involves level testing for matrix
π by examining whether the eigen value for π is significantly different from zero. There are some
conditions where it might which are: (i) r = k meaning
t
Z is stationary at the level, (ii) r = 0 meaning
t
Z is the autoregressive vector at first difference and (iii) 0 < r < k which means there is r linear
combination towards
t
Z which is stationary or cointegrated. This study also made use of the Trace (Tr)
eigen value statistic and Maximum (L-max) eigen value statistic (Johansen, 1988; Johansen and
Juselius, 1990). The Trace likelihood ratio test statistic is:
2
1
1
(1 )
p
r
Tr T In λ

+
= − −

)
(16)
130 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

where
p r
λ λ
) )
,.......,
1 +
is the smallest eigen value on the estimated r p − . The null hypothesis for the Trace
eigen value test is where there are most r cointegrating vectors. Meanwhile L-max can be calculated
as:
1
max (1 )
r
L TIn λ
+
− = − −
)
(17)
The null hypothesis for Maximum eigen value that the r cointegrating vector is tested compared
to alternative hypothesis on cointegrating vector 1 + r . If the Trace eigen value and Maximum eigen
value tests result in different decisions, then the decision result of Maximum eigen value test should be
used because the force of Maximum eigen value test is bigger when compared to Trace eigen value test
(Johansen and Juselius 1990).
The causal relationship issue in this research is tested using the Error Correction Model (Engle
and Granger, 1987). In association with ECM, a principal feature of cointegrated variables is that their
time paths are influenced by the extent of any deviation from long-run equilibrium. If the system is to
return to the long-run equilibrium, the movements of at least some of the variables must respond to the
magnitude of the disequilibrium. The dynamic model implied by this study is the one of error
correction. In an error correction model, the short term dynamics of the variables in the system are
influenced by the deviation from equilibrium.
Generally, time series variables which are not stationary should not be applied in the regression
model to avoid problems of spurious regression. There are some exceptions for this case where y
t
and
x
t
are non-stationary variables I(1), we expect that at the discriminating level or any linear combination
amongst those variables for example
0 1 t t t
y x ε α α = − − would also integrate at I(1). Even so, there are
more important cases that exist where
0 1 t t t
y x ε α α = − − are the stationary process of I(0). In such case,
y
t
and x
t
are also said to be cointegrated. Based on the cointegration test, if both
t
y and
t
x cointegrate,
then the said cointegration vector must be used as the error correction element (error correction term)
in modelling a short run relationship.
0 1 2
1 1
n n
t i t i j t j t
i j
y y x u α α α
− −
= =
= + + +
∑ ∑
(18)
0 1 2
1 1
m m
t i t i j t j t
i j
x y x v β β β
− −
= =
= + + +
∑ ∑
(19)
Generally, in the case where
t
y and
t
x are stationary variables I(0), equation (18) and (19) can
be estimated using the least squares method. However, if y
t
and x
t
are non-stationary variables, I(1) and
do not cointegrate, the VAR model such as in equation (20) and (21) in the first difference form can be
used. Whereas equation (22) and (23) can be used in cases where
t
y and
t
x are I(1) and cointegrated.
0 1 2
1 1
n n
t i t i j t j t
i j
y y x u α α α
− −
= =
∆ = + ∆ + ∆ +
∑ ∑
(20)
0 1 2
1 1
m m
t i t i j t j t
i j
x y x v β β β
− −
= =
∆ = + ∆ + ∆ +
∑ ∑
(21)
where
t
u and
t
v are stochastic errors. n and m are the selected lag length based on SIC. x
t
is Granger
causes y
t
if and only if the total of
2 j
α in equation (20) is significant and the total of
1i
β in equation
(21) is not significant. On the other hand, y
t
is Granger causes to x
t
if the total of
2 j
α in equation (20)
is not significant and the total of
1i
β in equation (21) is significant. If both the totals of
2 j
α and
1i
β are
significant, then there exists a bilateral causal relationship between y
t
and x
t
.
Meanwhile, if we assume all variables are I(1), in the case where y
t
and x
t
are cointegrated, the
following equation shall be used:
0 1 2 3 1
1 1
n n
t i t i j t j t t
i j
y y x z u α α α α
− − −
= =
∆ = + ∆ + ∆ + +
∑ ∑
(22)
131 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

0 1 2 3 1
1 1
m m
t i t i j t j t t
i j
x y x z v β β β β
− − −
= =
∆ = + ∆ + ∆ + +
∑ ∑
(23)
where
1 t
z

is error correction or cointegration obtained from cointegration tests. x
t
is Granger cause to
y
t
if the total of
2 j
α or
3
α in equation (22) is significant without taking into account
1i
β and
3
β . On the
other hand, y
t
would Granger cause to x
t
if the total of
1i
β or
3
β in equation (23) is significant without
taking into account
2 j
α or
3
α . Bilateral causal relationship exists between y
t
and x
t
if both the total of
2 j
α or
3
α and the total of
1i
β or
3
β are significant.
Coefficient
3
α and
3
β are referred to as error correction coefficients because both coefficients
show a number of variables in y
t
and x
t
reacting to the cointegration error which is
1 0 1 1 1 t t t
y x z α α
− − −
− − =
or
1 0 1 1 1 t t t
y x z β β
− − −
− − = . The rationale is that such error will lead to the correction caused by conditions
imposed upon
3
α and
3
β to ensure the stability conditions are fulfilled which are
3
( 1 0) α − < ≤ and
3
(0 1) β ≤ < . For example, the existence of a positive error,
1
0
t
z

> is due to
1 0 1 1
( ).
t t
y x α α
− −
> + A
negative error correction coefficient value
3
( ) α in the first equation which is equation (22) is to ensure
a decline in the variable y
t
(∆y
t
), while a positive error correction coefficient
3
( ) β in the second
equation which is equation (23) is to ensure a rise in the variable x
t
(∆x
t
). The values of both error
correction coefficients are less than 1 in absolute value to ensure that the said equation system does not
explode.


4. Empirical Results and Findings
All variable trends tend to increase over time from the year 1970 to 2007, except for the exchange rate
and foreign direct investment (see Figure 1). The results of the unit root tests based on ADF, PP, KPSS
and NP are shown in Table 1. All variables are stationary at first difference (both constant, and
constant & trend) excluding the FDI which is stationary at level (constant & trend), but stationary at
first difference if only constant taken into account (based on ADF and PP tests).
KPSS statistics under the null hypothesis of stationary also confirm that all variables have the
tendency to be stationary at first difference if only constant taken into account, while for constant and
trend, only the GDP, CE and GE showed stationary at first difference. Both the X and FDI on the other
hand are stationary at level, and for the ER is non stationary at both level and first difference.
NP test (only MZ
α
and MZ
t
statistics are shown in Table 1) is more robust and produced
interesting results. Although both statistics MZ
α
and MZ
t
produced mix results, both statistics have
tendency to reject the null hypothesis of a unit root at first difference (without concerned about the
assumption of constant, and constant & trend). The results using MZ
α
and MZ
t
tend to support
stationary for all variables at first difference (constant and trend), except for GE which is stationary
under the assumption of constant without trend.
Multiple cointegration tests using the Johansen approach is shown in Table 2. The results show
that there is more than one cointegrating vectors whereby there are four cointegrating vectors between
the GDP and other variables. In this study, we are not discuss more on the interpretation of these
number of cointegrating vectors due to the problems of interpretation when dealing more than one
cointegrating vector (see Maddala and Kim, 1998: 233-242). Nevertheless, this empirical decision
proposes that GDP and other variables could be cointegrated in the long run. Both statistic tests which
are Trace-eigen and Maximum-eigen statistic produced similar results. This gives the conclusion that
in the long-term GDP moves together with other variables towards equilibrium.
For causality issues, only one way direction is presented here from the determinant factors (as a
whole or individually) to the economic growth. The existence of a long-run cointegration relationship
needs equation (22) and (23) to be used as the cointegration vector or error correction elements need to
be inserted into the model. Equations (22) and (23) are Error Correction Model (ECM) which are said
132 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

to be based on the VAR’s framework. The VAR lag length order selections based on SIC suggest that
the optimum lag length is 1. The results of causality such as in Table 3 is quite interesting whereby
there is causal relationship running from the CE to the GDP as well as from X to GDP whereby all
variables as a whole are Granger caused to the GDP especially in the short-run. Meanwhile, the error
correction coefficient is also significant at the 10 per cent level showing that the GDP are responsive to
the discrepancy in error correction from long-run equilibrium (see Table 3). The negative sign of the
speed of adjustment coefficient are in accord with convergence toward the long-run equilibrium. The
imbalance between the GDP and all the determinant factors in this study is corrected or adjusted at a
fast pace of 0.93 or 93 per cent. In addition, the diagnostic tests (see Table 3) show that the residual
follow the normal distribution, no serial correlation, no heteroskedasticity, lastly there is no
autoregressive conditional heteroskedasticity.
These results lead to the conclusion that consumption expenditure and export play important
roles as determinant factors to a country’s economic growth especially in the short-run. In addition,
government expenditure, exchange rate and foreign direct investment are not the main important
determinant factors to the economic growth in Malaysia. As a whole, all the variables (combined
determinant factors) tend to cause the economic growth.

Figure 1: All Variables Trends

0
100000
200000
300000
400000
500000
600000
700000
800000
1970 1975 1980 1985 1990 1995 2000 2005
GDP
CE
GE
X
ER
FDI
M
Y
R

M
i
l
l
i
o
n

&

M
Y
R
/
U
S
D
Year


133 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

Table 1: Unit Root Tests

Test Type Variable
Level First Difference
Constant Constant & Trend Constant Constant & Trend
ADF
LGDP -1.59 (0) -2.18 (0) -4.99***(0) -5.19***(0)
LCE -0.97 (1) -2.85(1) -4.34***(0) -4.35***(0)
LGE -1.09 (0) -1.99(0) -5.88***(0) -6.03***(0)
LX -0.98 (0) -2.11(0) -6.11***(0) -6.26***(0)
LER -1.23 (0) -2.85(0) -5.98***(0) -5.95***(0)
LFDI -1.63 (1) -3.49(0) -8.16***(0) -8.09***(0)
PP
LGDP -1.55 [1] -2.22[1] -4.96***[2] -5.15***[2]
LCE -1.13 [1] -2.31[1] -4.26***[3] -4.27***[3]
LGE -1.10 [1] -1.99[1] -5.90***[2] -6.04***[2]
LX -1.14 [6] -2.11[0] -6.11***[0] -6.44***[2]
LER -1.23 [0] -2.83[3] -5.99***[4] -5.97***[5]
LFDI -2.20 [2] -3.54*[3] -8.18***[1] -8.10***[1]
KPSS
LGDP 0.75*** [5] 0.14*[4] 0.24[2] 0.07[1]
LCE 0.75*** [5] 0.14*[4] 0.19[0] 0.07[1]
LGE 0.74*** [5] 0.13*[4] 0.17[1] 0.10[1]
LX 0.74*** [5] 0.09[4] 0.14[3] 0.07[5]
LER 0.50** [5] 0.16**[4] 0.20[3] 0.12*[4]
LFDI 0.70** [5] 0.10[4] 0.13[2] 0.06[2]
NP
MZ
α
MZ
t
MZ
α
MZ
t
MZ
α
MZ
t
MZ
α
MZ
t

LGDP
0.19
(3)
0.10
(3)
-3.96
(0)
-1.37
(0)
-18.07**
(0)
-2.98**
(0)
-18.01**
(0)
-2.97**
(0)
LCE
-0.02
(3)
-0.00
(3)
-4.50
(0)
-1.49
(0)
-16.91**
(0)
-2.90**
(0)
-17.21*
(0)
-2.92**
(0)
LGE
0.13
(2)
0.07
(2)
-4.31
(0)
-1.47
(0)
-8.25**
(1)
-2.01**
(1)
-10.42
(1)
-2.28
(1)
LX
0.46
(4)
0.28
(4)
-8.53
(0)
-1.95
(0)
-3.06
(3)
-1.24
(3)
-16.64*
(0)
-2.87*
(0)
LER
-3.05
(0)
-1.20
(0)
-5.44
(0)
-1.65
(0)
-5.68
(6)
-1.67*
(6)
-19.33**
(1)
-3.07**
(1)
LFDI
0.34
(1)
0.21
(1)
-7.29
(1)
-1.90
(1)
-10.57**
(6)
-2.29**
(6)
-42.36**
(7)
-4.60**
(7)
Notes: Figures in () and [ ] indicates number of lag and bandwidth structures respectively. *, **, *** indicates
significance at 10%, 5% and 1% levels respectively.

Table 2: Johansen Multivariate Cointegration Test

H
0
H
1

Test Statistic: λ
Trace Statistic:
trace
λ
r = 0 r > 0 267.9052***
r ≤ 1 r > 1 168.5012***
r ≤ 2 r > 2 90.9044***
r ≤ 3 r > 3 40.7252***
r ≤ 4 r > 4 9.8093
r ≤ 5 r > 5 1.1328
Max-Eigen Statistic:
max
λ
r = 0 r = 1 99.4040***
r = 1 r = 2 77.5968***
r = 2 r = 3 50.1792***
r = 3 r = 4 30.9159***
r = 4 r = 5 8.6765
r = 5 r = 6 1.1328
Notes: *** denote significant at the 1% level.
134 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

Table 3: Error Correction Model: Multivariate and Bivariate Causality Test

Variable VAR(k) Wald Statistic
Dependent Variable: ∆LGDP
∆All ⇒ ∆LGDP
1
14.8737**
∆LCE ⇒ ∆LGDP
8.6597***
∆LGE ⇒ ∆LGDP
1.7954
∆LX ⇒ ∆LGDP
5.2877**
∆LER ⇒ ∆LGDP
0.0696
∆LFDI ⇒ ∆LGDP
0.3869
Variable VAR (k) t-Statistic
1 t
z


1 -0.9720*
Diagnostic Tests
R
2
= 0.3801 SIC = -2.1592 JB = 0.6320
White Statistic = 17.6841 Q(1) = 0.0018 LM(1) = 0.0062
Sum of Squared Residual = 0.1097 Q
2
(1) = 2.1550 ARCH(1) = 2.6847
Notes: ***, **, * denote significant and rejected at the 1%, 5% and 10% levels respectively. Q = Q-statistic for
correlogram of residuals, Q
2
= Q-statistic for correlogram of squared residuals, JB = Jarque-Bera statistic, LM =
Breusch-Godfrey Serial Correlation LM statistic, and ARCH = Autoregressive Conditional Heteroskedasticity
statistic. Figures in () indicates number of lag structures selected based on the SIC. The results for multi-ways
causal relationship between GDP and other variables (determinant factors) are available from the authors upon
request


5. Discussion and Conclusion
Economic stability is given special attention by many countries. This is because a stable economy
portrays a positive image and good economic positioning. Strong economic stability also becomes an
attraction for other countries to invest and also act as a guarantee on investments made. It can therefore
be said that the deciding factor on whether a country is successful or not can be seen from its economic
stability. Hence, factors determining economic stability must be given due attention. The determinant
factors such as exports, foreign direct investment, government expenditure, domestic consumption, and
exchange rate can be a threat to the stability of country if they are not managed well.
One might consider that by improving institutions or the way of how economy operates, we can
change our economic outcomes for the better. When institutions are weak, even places with abundant
natural resources or other inputs will not promise high and sustain economic growth. Good governance
and well managed economic resources are also important in order to sustain economic growth.
Economic growth is the result of a variety of influencing factors, which can only be
approximate by growth theory. Historically, the simple growth models were extended over time by
relaxing the model restrictions and supplementing new variables over time (as in this study) to give a
better explanation on economic growth. This study also confirmed empirically the success of the
export-led growth strategy.
Our research showed that consumption expenditure and exports play an important role in
boosting economic growth in Malaysia. More emphasis should be accorded on these determinant
factors when drafting related economic policies of a country. Our study also found that the effect and
role of government expenditure, exchange rate and foreign direct investment on economic growth may
be less important. Nevertheless, this does not mean that the importance of these factors in spurring
continuous economic growth should be ignored. Rather, these variables may be viewed as a catalyst
and complement factors of economic growth.
Our findings have important implications on policy reform. Policies to promote economic
growth should be based on evidence of what has, and what has not, worked for other countries.
Evidences presented here compared to previous studies (in the literature review) are mixed and that
economic growth is significantly influenced by various factors. In addition, while other reasons have
135 European Journal of Economics, Finance and Administrative Sciences - Issue 24 (2010)

been suggested in the literature, but the questions that one might concern with are: how can we
replicate this in Malaysia? Can we uncover which are the best policies tending to promote economic
growth? Should we suggest that the consumption expenditure and the export are the best determinant
factors of economic growth? These questions are still pending and need further investigation.


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