WEEK 2 Rajah Rasiah-Chapter 02 - Macroeconomic Policies

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Malaysian Economy
Ch. 2: 1
© Oxford Fajar Sdn. Bhd. (008974-T) 2011
Chapter 2
Macroeconomic Policies
Eu-Chye Tan
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Malaysian Economy
Ch. 2: 2
Learning Objectives
 The execution of fiscal, monetary and exchange rate

policies in Malaysia
 Fiscal deficits are not invariably bad for an economy
 The instruments of monetary policy at the disposal
of the Central Bank
 The evolution of monetary aggregates and their
velocities in Malaysia
 The actual exchange rate arrangement of Malaysia
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2.0 Introduction
 Focus is on fiscal, monetary and exchange rate

policies in Malaysia
 Fiscal and monetary policies are demand
management policies
 These policies influence output, employment,
inflation, exchange rate and balance of payments
 Exchange rates also potentially affect domestic
macroeconomic variables
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2.0 Introduction (cont.)
 Malaysia—a very open economy—is very much
influenced by international trade and capital flows.
 A judicious mix of monetary, fiscal and exchange
rate policies is needed to address both internal and
external shocks.
 Generally, central banks or monetary authorities are
more concerned with the need to maintain price
stability.
 Fiscal authorities place greater weight on economic
growth and low unemployment.
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Malaysian Economy
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2.0 Introduction (cont.)
 High economic growth or low unemployment and
price stability or low inflation are conflicting
objectives.
 Nevertheless, in Malaysia, monetary policies more
often than not would complement fiscal policies in
meeting the objectives of high employment, price
stability and economic growth.
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2.1 Fiscal Policy
 Fiscal policy may be pursued in an activist or
discretionary manner.
 E.g. in the Keynesian spirit, in the event of a negative
shock to aggregate demand, deficit fiscal policy may
be observed. When the economy is overheating, a
surplus fiscal policy may be pursued.
 Fiscal policy may also be passively pursued, acting
as an automatic stabilizer of the economy. In an
economic upswing, government’s fiscal position tends
towards a surplus. In an economic downturn, it tends
towards a deficit.
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Malaysian Economy
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2.1 Fiscal Policy (cont.)
 Government’s involvement in the economy via fiscal
policy manipulation is not invariably bad but could
be catalytic to development.
 E.g. promoting investment in the manufacturing
sector by spending on infrastructure, by granting
fiscal incentives to firms—generate employment,
poverty alleviation, etc.
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 Constant observation of balanced budget
 But this denies fiscal policy its stabilization role in
the event of adverse shocks to the economy
 When output is below the potential level, budget
deficits may be the right move.
 If balanced budget is observed, no discretionary
counter-cyclical policy can be initiated.
 Unemployment would be aggravated, economic
recovery process stalled causing greater economic
misery.
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 Chronic budget surpluses may indicate inefficiency
of resource utilization.
 Government may be unduly amassing resources
which could otherwise be more efficiently used by
the private sector.
 Fiscal drag would be the outcome
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 Fiscal prudence has been a stance of the Malaysian
federal government.
 Figure 2.1 shows that the federal government has
been sustaining a fiscal deficit in all the years
(1966–2009) except from 1993 through 1997.
 However, deficit has been sustained due to
operating spending.
 The figure shows an operating surplus in all the
years except 1972, 1986 and 1987.
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Figure 2.1 Federal government fiscal surplus/deficit, 1967–2009
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 Federal government displays increasing prudence in
managing fiscal position.
 Figure 2.2 shows the overall fiscal deficit/surplus as
a percentage of GDP and its external debt service
ratio.
 The relative size of the fiscal deficit has been
shrinking
 Drastic fall in the external debt service ratio
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Figure 2.2 Federal government fiscal surplus/deficit versus external debt, 1970–2009
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 Panel A of Table 2.1: Correlation coefficients
between changes in M0 and changes in fiscal deficit
 No practice of monetization of fiscal deficits via
printing money
 Panel B: Correlation coefficients between the real
GDP growth rate and changes in the overall real
fiscal deficit
 Fiscal policy has not been pursued counter-
cyclically when viewed over a long run
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Table 2.1 Some estimated correlation coefficients
Panel A Correlation between changes in M0 and in federal government
deficit
1968–2009 −0.319
1968–1985 −0.135
1987–2009 −0.491
Panel B Correlation between GDP growth and changes in the overall
federal government deficit
Contemporaneous One-period lag
1968–2009 −0.364 −0.061
1968–1985 −0.110 0.334
1987–2009 −0.537 −0.229

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Inferences
 Fiscal prudence maintained over the years
 Fiscal deficits largely by non-inflationary domestic
sources with limited inflationary sources
Consequences
 Fiscal deficits mainly due to development spending
that enhances the future revenue stream of the
government
 Possible absence of trade-offs between inflation and
unemployment
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 Factors possibly contributed to negative or weak
correlation between fiscal deficit and inflation:
• Deficit financing via issuance of domestic bonds
• Wage and price inertias
• Public expectations about the future direction of
fiscal policy
• More fundamental causes of inflation
• Ricardian equivalence
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2.2 Monetary Policy
 The Central Bank is responsible for the

administration of monetary policy
 Monetary policy objectives—sustainable economic
growth, low unemployment, price stability and a
satisfactory balance of payments position
 As a developing economy, economic development
of the country also becomes an important objective
of the Central Bank
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2.2 Monetary Policy (cont.)
 Policy dilemma over the need to foster economic

growth and the need to maintain price stability—
conflicting objectives
 Excessive growth of money has inflationary
consequences
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 Table 2.2 shows the trend and periodic average

rates of growth of real GDP and the various real
monetary aggregates
 No excessive growth of money supply (M0)
 However, growth of money supply (M1, M2 and M3)
outpaced the growth of real GDP
 Nevertheless, this is due to continuous process of
monetization and growth of financial intermediation
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Table 2.2 Rates of growth of monetary aggregates and GDP in real terms (%)
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 Liquidity and cost of funds is regulated via monetary
policy instruments
 Monetary policy instruments—general and selective
 General instruments—general impact on the whole
economy
 Selective instruments—selective impact on only
certain sectors
 General and selective instruments may be
complements rather than substitutes
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The instruments:
• Statutory reserve ratio
• Minimum liquidity ratio
• Centralization of Government and Employees
Provident Fund Deposits with the Central Bank
• Open market operations
• Direct borrowing or lending operations
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• Discount operations
• Limits on swap transactions with foreign
customers
• Moral suasion
• Credit controls and guidelines on lending
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 Definitions of the various monetary aggregates:
• M0—currency-in-circulation
• M1–M0 plus demand deposits held by the private
sector
• M2–M1 plus savings and fixed deposits of the
private sector at commercial banks, net issues of
NCD (negotiable certificates of deposit) to the
private sector by the commercial banks and repo
transactions affected by the commercial banks
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• M3–M2 plus savings and fixed deposits of the

private sector at finance companies, merchant
banks, discount houses and Bank Islam, net
issues of NCD to the private sector and repo
transactions affected by these institutions.
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 Figure 2.4 plots M0, M1, M2 and M3 from 1973
through 2009
 Sharper increase is seen over the years in M2 and
M3 than in M0 and M1
 This can be explained by underlying increase in
financial intermediation, increased moneyness of
savings and time deposits
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Figure 2.4 Monetary aggregates, 1973–2009
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The choice of the appropriate guide for monetary

policy actions is based on:
i. Strength of the relationship between a monetary
aggregate and the aggregate output or some other
ultimate goal variable
ii. Stability of the relationship over time and its
predictive power
iii. Stability of the relationship between the monetary
aggregate and the policy instruments
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 M1 was the most appropriate choice for monetary
policy purposes before the 1980s
 M2 and M3 have closer relationships with economic
activity since the early 1980s
 Since 1984, M3 has become the intermediate
monetary target though M1 and M2 are still being
monitored
 However, rapid developments in the financial
system have undermined the relationships between
monetary aggregates and economic activity
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 Therefore, other indicators have been increasingly
focused upon
 Efficacy of monetary policy hinges on the stability of
the money demand function
 Figure 2.5 shows plots of the income velocities of
circulation of money
 Demand for M0 is unstable as it has an upward trend
velocity
 Velocities of M1, M2 and M3 assume a downward
trend though less marked
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 Velocity of M3 is stable from 1998 onwards
 Monetary targeting was the monetary policy strategy
before the switch to interest rate targeting in the
mid-1980s
 Whether targeting interest rates or monetary
aggregates is more appropriate depends on the
origin of uncertainty
 If the source of uncertainty is mainly in the goods
market, it could be better to have monetary targeting
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 If the source of uncertainty is mainly in the money
market, interest rate targeting could be appropriate
 Money demand functions have become unstable with
globalization and development of financial markets
 Therefore, interest rate targeting would be a more
appropriate choice
 It is also desirable if interest rate stability matters
 It is also favoured due to greater controllability and
measurability
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 Interest rate data are more timely available
 Inflation targeting is also being practiced e.g. in
Canada, New Zealand, the United Kingdom and
Sweden
 This could pre-empt time inconsistency problems
 Impact of monetary policy is usually not felt
instantaneously
 The Central Bank may maintain some independence
from the government for a low-inflation environment.
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2.3 Exchange Rate Policy
 The Malaysian dollar was fixed at 2s.4d. sterling

prior to June 1967.
 Malaysia adopted the US dollar in place of the
sterling as the intervention currency on 24 June
1972.
 Malaysia allowed floating of its currency on 21 June
1973.
 This marked the termination of the early fixed
exchange rate in Malaysia.
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2.3 Exchange Rate Policy (cont.)
 Floating would provide greater leeway for pursuing

domestic economic stabilization policy
 However a ‘clean’ float was never intended
 The Central Bank continued to intervene in the
foreign exchange market whenever there was
excessive fluctuation in the exchange rate.
 Basket pegging was instituted in 27 September
1975.
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 However amid the 1997–1998 East Asian financial

crisis, the Central Bank resorted to pegging the ringgit
to the US dollar at RM3.80 from 2 September 1998 in
addition to imposition of selective exchange controls
 Rationale—to provide a breathing space for Malaysia to
adopt macroeconomic policies to revive the economy
from the spillover effects of the East Asian financial
crisis.
 The exchange controls were subsequently phased out
and Malaysia reverted to managed float on 21 July
2005.
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 Managed float—combines elements of the fixed and

flexible exchange rate systems
 Under the system, exchange rate could respond to
market forces though there would be intervention to
stem out disruptive exchange rate movements
 There are advantages and disadvantages of the
fixed and the flexible exchange rate systems.
 Fixed exchange rate system—a stable environment
for international trade and capital flows
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 Flexible exchange rate system—policy-makers can

focus on domestic economic goals
 Exchange rate flexibility—resolves the potential
conflict between internal and external balances
 However, exchange rate movements do matter
 E.g. inflation could be fuelled by depreciation of the
domestic currency
 Competitiveness of exports could be compromised
by a strong domestic currency
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 Increased risk in international trading of goods and

capital
 Wasteful resource allocation and frictional
unemployment
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2.4 Conclusion
 Malaysia has been maintaining fiscal prudence and

hence fiscal deficit do not present an acute problem.
 Monetary policy—maintaining price stability,
fostering economic growth and development,
represents important objectives of the policy.
 Malaysia’s current exchange rate system is one of
managed float to contain unwarranted speculative
movements in the exchange rates.
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Malaysian Economy
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WEEK 2 Rajah Rasiah-Chapter 02 - Macroeconomic Policies

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 The execution of fiscal, monetary and exchange rate

All Rights Reserved

 Focus is on fiscal, monetary and exchange rate

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

Panel A Correlation between changes in M0 and in federal government

federal government deficit

Contemporaneous One-period lag

1968–2009 −0.364 −0.061

1968–1985 −0.110 0.334

1987–2009 −0.537 −0.229

All Rights Reserved

 The Central Bank is responsible for the

All Rights Reserved

 Policy dilemma over the need to foster economic

All Rights Reserved

 Table 2.2 shows the trend and periodic average

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

• M3–M2 plus savings and fixed deposits of the

All Rights Reserved

All Rights Reserved

All Rights Reserved

The choice of the appropriate guide for monetary

All Rights Reserved

All Rights Reserved

All Rights Reserved

All Rights Reserved

 The Malaysian dollar was fixed at 2s.4d. sterling

All Rights Reserved

 Floating would provide greater leeway for pursuing

All Rights Reserved

 However amid the 1997–1998 East Asian financial

 Managed float—combines elements of the fixed and

All Rights Reserved

 Flexible exchange rate system—policy-makers can

All Rights Reserved

 Increased risk in international trading of goods and

All Rights Reserved

 Malaysia has been maintaining fiscal prudence and

All Rights Reserved

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