Econometric analysis of Malaysian monetary policy

Over the years, many economies around the world have evolved in line with globalization and liberalization processes and have witnessed widespread changes in their conduct of monetary policy and the choice of monetary policy regimes. These processes have opened up new avenues and increased opportunities for financial market developments with greater financial integration and strong capital flows. The changing economic and financial environments have made modelling monetary policy and the identification of monetary policy shocks very challenging, particularly in small emerging open economies. To date, not much research work has been carried out on these economies, and this thesis attempts to fill this gap by addressing the problems associated with modelling monetary policy and the complexities involved in estimating monetary policy shocks and impulse response functions. In this thesis, we investigate the monetary transmission mechanism of the Malaysian economy, which provides an interesting case study to examine the effects of monetary policy on the real sectors of the economy under different exchange rate regimes. Malaysia adopted a managed float exchange rate regime prior to the 1997 Asian financial crisis and subsequently a pegged (to US dollar) exchange rate regime following the crisis. The specific aims of this research are: (i) To establish the necessary identification conditions to uncover Malaysian monetary policy shocks; (ii) To examine whether or not the identified model can resolve economic puzzles commonly found in monetary policy empirical literature; (iii) To evaluate the effectiveness of monetary policies on price levels and economic activities during the pre- and post-1997 Asian financial crisis periods; and (iv) To assess the strength of various monetary transmission channels such as interest rates, monetary aggregates, credits, asset prices and exchange rates in propagating monetary policy shocks under different exchange rate regimes. To achieve the above aims, we employ three different modelling strategies: (i) the vector autoregressive (VAR); (ii) the structural vector autoregressive (SVAR); and (iii) the vector autoregressive moving average (VARMA) models. The traditional VAR approach is used as a first step to conduct some preliminary analysis, and to develop and analyze the effects of Malaysian monetary policy. Subsequently, the SVAR models are used to address issues concerning the contemporaneous relationships between Malaysian macroeconomic variables and policy instruments. We establish identification restrictions that are broadly consistent with economic theory and stylized facts that are evident in prior empirical research findings. One of the important characteristics of our identified SVAR model is the set of foreign block exogeneity restrictions which we impose to reflect the fact that small open economies do not influence large economies. Further, under the managed and pegged exchange rate systems, we uncover the importance of various monetary channels through which monetary policy shocks affect the Malaysian economy. The VARMA models are found to be superior to the VAR-type models for forecasting economic and financial variables. However, VARMA models are rarely used in empirical studies of monetary policy analysis. We are among the first to apply this methodology to investigate the responses of Malaysian variables to various monetary shocks and to assess whether they are consistent with prior theoretical expectations and stylized facts. The attractiveness of the VARMA model is that its impulse response functions reveal the expected monetary policy effects on the Malaysian economy, particularly in the postcrisis period under the pegged exchange rate system. On the other hand, the VAR and SVAR models fail to generate reliable impulse responses in some cases. The overall results suggest that the crisis, and a subsequent major shift in the exchange rate regime, have affected the Malaysian monetary transmission mechanism. Malaysian domestic variables are more sensitive and volatile to both domestic and foreign monetary shocks under the managed float exchange rate system than under the fixed exchange rate system. Hence, it is apparent that the stringent capital control measures undertaken by the government in the post-crisis period have insulated the Malaysian economy to some extent against foreign shocks and have provided the desired monetary autonomy. Considering some disparities in the effects of monetary policy on the Malaysian economy during the pre- and post-crisis periods, it is essential that policy makers understand how the economic transformation, the openness of the economy and the growing integration with external economies affects the nature of the monetary transmission mechanism. In our investigations, we uncover how various transmission channels work and we believe the outcome of our study can help the Malaysian Central Bank to steer the economy in the right direction, so that monetary policy can still remain an effective policy measure in achieving sustainable economic growth and price stability. In addition, the methodologies used in this thesis and the empirical findings will also enhance future research on similar small emerging open economies in devising appropriate monetary policy strategies under different policy regimes.