How Malaysia Government Can Reduce Inflation Rate by Using Monetary and Fiscal Policy

3359 Words May 11th, 2013 14 Pages
Are monetary disturbances and fiscal deficits inflationary? Empirical evidence from Malaysia
Associate Professor Dr Tan Juat Hong College of Graduate Studies, Universiti Tenaga Nasional, Malaysia

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.

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In 1981 the budget-deficit stood at 15.6% of nominal GDP; while in 1982, it hit its peak at 16.6% of GDP. Nevertheless, the Malaysian government managed to balance its fiscal budget from year 1993 till 1997. This period saw a budget-surplus policy corresponding to a local bullish market with high commodity prices in the early 1990s. A budget surplus of 2.4% of nominal GDP was attained in 1997. However, the contagion effect of the 1997/98 financial crisis from neighbouring Thailand exerted a negative impact on the Malaysian economy. Malaysia succumbed to the financial crisis in 1998 with declining real output and increasing unemployment, much to the chagrin of the government. Malaysia’s fiscal policy after the 1998 financial crisis has been a budget-deficit strategy to boost output growth as well as to reduce unemployment. In 2009, the government budget deficit stood at 7% of nominal GDP (see Figure 2). Figure 3 depicts the percentage annual change of broad money supply (M2) for the period 1970 till 2009. Fundamentally, Bank Negara Malaysia, the Malaysian monetary authority, adopted a discretionary monetary policy to stabilise the country’s financial sector and macroeconomic issues. In his study, Tan (2006) finds that monetary policy tends to respond more vigorously to aggregate demand shocks as compared to aggregate supply shocks. He concludes that monetary policy’s positive response to aggregate demand shocks is countercyclical,…