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.
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 GDP growth of 6.3% in the same year. The inflationary trend for Malaysia is depicted in Figure 1. The inflation rate is computed by taking the percentage annual change of the Consumer Price Index (CPI). The inflationary trend rose steadily in 1970 to its height of 17.4% in 1973. Another spike in the inflation rate at 9.7% was in 1981, perhaps due to the aftermath of the oil embargo in 1978/79. The Malaysian government began to implement supply-side economic measures such as price controls of essential items to moderate inflation. These measures manage to stabilise the general price level. Inflation hit its lowest level in the mid-1980s due to plunging commodity prices. During the financial crisis of 1998, inflation was at 5.3% due primarily to exchange rate fluctuation and high volatility. When the economy started to recover in the late 1990s, inflation began its upward trend. Implicitly, Malaysian authorities are trying to establish a target-inflation framework supported by a freely-managed exchange rate regime. Barring any unforeseen circumstances, an annual target of inflation rate of 3% - 4% was announced. To support this range of inflation-targeting, the government continues to use the supply-side economics such as price controls and subsidies to bring down inflation. These policies were effective in sustaining the inflation-target strategy despite high oil prices in world market especially in the 1970s. On the other hand, the essential price controls and subsidies implemented to subdue inflation distort the free market mechanism. Despite all these supply-side measures, the annual inflation rate stayed at 5.4% in 2008. However, although it dipped to 0.2% in 2009 that could be easily attributed to the domestic economic slowdown resulting from the global economic crisis (see Figure 1).
Figure 2 depicts the fraction of government finance (revenue – expenditure) as a percentage of nominal Gross Domestic Product (GDP). Since the 1970s, the...