Effects Of Inflation On The Malaysian Economy Economics Essay

1.0 Introduction

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time (Wyplosz & Burda 1997 and Blanchard 2000). When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation is also erosion in the purchasing power of money which means a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

While economic growth is the increase of per capita gross domestic product (GDP) or other measure of aggregate income. It is often measured as the rate of change in GDP. Economic growth can be either positive or negative. Negative growth can be referred to by saying that the economy is shrinking. Negative growth is associated with economic recession and economic depression. In order to compare per capita income across multiple countries, the statistics may be quoted in a single currency. To compensate for changes in the value of money (inflation or deflation) the GDP or GNP is usually given in “real” or inflation adjusted, terms rather than the actual money figure compiled in a given year, which is called the nominal or current figure.

Moreover, inflation’s effects for the economy growth can be simultaneously positive and negative. Both effects of inflation may due to many reasons, for example, negative effect may due to decrease in the real value of money and other monetary items over time, while positive effect can include a mitigation of economic recessions, and debt relief by reducing the real level of debt. High rates of inflation and hyperinflation can be caused by an excessive growth of the money supply. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

There is a growing consensus among economists on the distortional effects of inflation on long-term economic growth. Yet, the empirical evidence on the relationship between inflation and economic growth has been surprisingly mixed and elusive. The conventional view in macroeconomics holds that low inflation is a necessary condition for fostering economic growth. Although the debate about the precise relationship between inflation and growth remains open, the question of the existence and nature of the link between inflation and economic growth has been the subject of considerable interest and debate. Different schools of thought offer different evidence on the relationship between inflation and growth. For example, there is exists the inflation and economic growth are positively related (Mallik and Chowdhury, 1, June 2001), while (Barro, 1991; Fischer, 1993; Bullard and Keating, 1995) found out that there is a negative relationship between inflation and economic growth.

This paper we attempt to examine the relationship between inflation and economic growth and estimate the threshold level of inflation for Malaysia. The empirical literature has posited ad hoc thresholds in the relationship between inflation and economic growth. The theoretical literature has argued that there are thresholds in the relationship among inflation and economic growth, and that the interaction of inflation has affects the economic growth. This paper systematically examines the empirical and theoretical postulates using Khan and Senhadji (2001) panel threshold methodology to test for and estimate thresholds model, where the relationship between growth and inflation becomes progressively more general.

1.1 Research Background

Malaysia has been relatively successful in balancing strong economic growth with moderate levels of inflation in the periods preceding and following the Asian Crisis. Yet, the exit from the seven-year-old exchange rate peg in July 2005 and the recent adjustment in administered fuel prices call for a better understanding of the determinants of inflation. Nevertheless, there is some reason behind the inflation. The reason behind the inflation is due to several current factors happen to the world. It also been causing by the internal factor that help worsens the situation. The first factor is because the increase of crude oil price. It infect country gas price to increase too because government cannot stand the subsidies increase. Current price of crude oil has increase to USD 150 a barrel, that cause Malaysia to face 7.7 percent inflation on June 2005 and increase again on July 2005 to 8.5 percent. The increment of the natural resource price has increase the price of local gas to rm 2.7 per liter than before from rm 1.92. It’s been followed by the increase of the local goods such as cooking oil, flour, and rice and other in that year. The local trader has taking the advantages to increase the prices of good due to the reason of oil price increase. The value of ringgit has turn down and lowering its value because of the local traders act. By increase the price of good, the value that previously can buy good in certain quantity, has goes down that only by the same good but in the less quantity than before.

The inflation in Malaysia also occurs because of the increment of salary and wages and also new announcement by the government. After a few day of the announcement, various type of necessary good increase. It is done by the local retailer and shop owner to gain profit from the situation. The inappropriate act by the local trader gives the kick start to Malaysia inflation to grow. Later, the government has come out with many type of control to decrease the price of good but the trader has worsen it better by hiding the good to increase the price back.

From that reasons above, clearly we can see the main cause of Malaysia inflation is done by the inner problem itself. The act of local retail and traders is the biggest contributor to the inflation. Although many people can see the general effect of the increase of crude oil causing the inflation rate increase, but the government has absorb the burden by giving the subsidies to many necessary good to reduce the cost. It cannot be the best reason to local trader to increase price of good in the market that tend to increase the inflation.

Figure1 : relationship between Inflation Rate and GDP Growth

Just a few years after independence from the United Kingdom in 1957, had the World Bank’s country-classification system been in place, Malaysia would have qualified as a middle-income country. The growth performance of the Malaysian economy has been very impressive. The average annual growth rate of real income (real income per capita) was 6.4 percent (3.7 percent) over the years 1961-1995. Since then, it has continued to enjoy relative prosperity, initially as a commodity exporter (rubber, tin, then palm oil and petroleum), with total income rising at 6-7 percent each year from 1970 until 2000. With a per capita yearly income measured at about US$5,300 in 2007, Malaysia is now an upper-middle-income country.

During the 1970s, Malaysia followed the footsteps of the original four Asian Tigers and committed itself to transition from reliance on mining and agriculture to manufacturing. With Japan’s assistance, heavy industries flourished and in a matter of years, Malaysian exports became the country’s primary growth engine. Malaysia consistently achieved more than 7% GDP growth along with low inflation in the 1980s and the 1990s. Current GDP per capita grew 31% in the 1960s and an amazing 358% in the 1970s, but this proved unsustainable and growth scaled back sharply to 36% in the 1980s. It rose again to 59% in the 1990s led primarily by export-oriented industries. The rate of poverty in Malaysia also fell dramatically over the years. However, its precipitous drop has been questioned by critics who suggest that the poverty line has been drawn at an unreasonably low level.

Low inflation and sustainable GDP growth has been one of the main features of the Malaysia economy in the last two decades. Nevertheless, the abandonment of the explicit anchor represented by the seven-year-old exchange rate peg in July of 2005 and the recent rise in inflation underscores the need for a better understating of inflation dynamics in Malaysia. Despite its robust economic growth in 1980s and 1990s, Malaysia’s inflation rate had been relatively low by international standards. Even after the severe Asian financial crisis (1997 and 1998) and sharp depreciation of the ringgit in 1997-98, Malaysia’s inflation rate has been contained at a relatively low level.

In the early 1960s, Malaysia’s inflation has a negative rate that was -0.18 per cent while the growth rate of GDP was approximately 4.3 per cent. The GDP growth rate average fluctuate during 1960s but it was decrease sharply in year 1967 which state at 0.7 per cent while the inflation rate still occur negative amount accept the year 1962, 1963, 1966, and 1967 have a positive inflation rate (0.1%, 3.11%, 0.1%, and 4.6%).

The investigations into the existence and nature of the link between inflation and growth have experienced a long history. Although economists now widely accept that inflation has a negative effect on economic growth, researchers did not detect this effect in data from the 1950s and the 1960s. A series of studies in the IMF Staff Papers around 1960 found no evidence of damage from inflation (Wai, 1959; Bhatia, 1960; Dorrance, 1963, 1966). Johanson (1967) found no conclusive empirical evidence for either a positive or a negative association between the two variables. Therefore, a popular view in the 1960s was that the effect of inflation on growth was not particularly important.

While in the 1970s, Malaysia experienced a single-digit episode of inflation at around 2 per cent while the growth rate of GDP was approximately 3.17 per cent. The GDP growth rate has a negative rate during the second half of the 1970s while inflation rate gradually increased to 4.5 per cent. The sharp oil price increase in 1973 and 1974 was the principal reason for the escalation of world inflation in 1973-74. Consequently, consumer prices in Malaysia began to rise and inflation had reached a double-digit level of 9.24 per cent by the end of 1973. In 1974, the surge in oil price, and the inflation rate in Malaysia increased to its record high of 17.32 per cent. A year later, the Malaysian economy slumped into its great recession, with a GDP growth rate of -1.66 per cent in 1975, compared with 9.23 per cent and 6.08 per cent in 1973 and 1974 respectively. On the other hand, inflation rate reduced to the level of 4.5 per cent in 1975.

Malaysia experienced a second episode of high prices in 1980 and 1981, which were due mainly to external factors. Oil prices rose by 47 per cent in 1979 and 66 per cent in 1981. As a result, inflation in Malaysia accelerated from 3.6 per cent in 1979 to 6.7 per cent and 9.7 per cent in 1980 and 1981 respectively. Consequently, GDP declined to 5.25 per cent and 3.8 per cent in 1980 and 1981 respectively, compared with 7.3 per cent in 1979. However, since 1982 inflation rate kept decreasing, and it amounted to less than 1 per cent in 1985, 1986, and 1987. The development of the Malaysian economy was at an important crossroad in 1985. The economic performance of the country slumped into its greatest recession, -3 per cent and 1.66 per cent growth rates were recorded in 1985 and 1986 respectively. The severity of the international economic recession during the early 1980s imposed considerable constraints on the growth and development of the nation in 1985 and 1986.

After registering a significant growth of more than 6 per cent for three consecutive years, with inflation rate as low at 2.6 per cent, the economy in 1990 strengthened further in the country despite some slowing down of growth in the industrial countries. Although inflation rate increased, on average, to 3.9 per cent during the period 1991-96, the growth rate of GDP continued to increase and reached 7.8 per cent. However, with the outburst of the financial crisis in Asia in 1997, interest rates, fuel prices, and prices of goods and services have increased. Robust foreign demand as a result of the depreciation of the Malaysian ringgit (RM) of over 40 per cent placed an extremely powerful inflationary pressure on Malaysia. As a result, inflation rate increased to 5.3 per cent in 1998, compared with 2.7 per cent in 1997. Consequently, in 1998, Malaysian economy experienced a sharp decline in the growth rate of GDP from positive growth rate to negative, at -5.9 per cent, compared with 4.5 per cent in 1997.

The broad-based growth that began in 2000 decelerated sharply in the first half of 2001 on a year-on-year basis to 1.7 percent, from 9.7 percent in the second half of 2000. The slowdown is explained by the drop in exports of electrical and electronic products and the knock-on effect on private consumption and gross fixed investment. Malaysia narrowly avoided a return to recession in 2001 when its economy was negatively impacted by the bursting of the dot-com bubble (which hurt the ICT sector) and slow growth or recession in many of its important export markets. The global financial crisis threw Malaysia into recession again in 2009, and the government expects a contraction in GDP of around 3% for the year. Economists expect Malaysia to return to a positive growth path in 2010. Between 2000 and 2005, inflation rate stabilized and remained approximately around 1.7 per cent, but with the low growth rate of GDP of -1.6. In 2005, the government removed the 7-year-old peg linking the ringgit’s value to the U.S. dollar at an exchange rate of RM 3.8/U.S. $1.0. The dollar peg was replaced by a managed float against an undisclosed basket of currencies. The new exchange rate policy was designed to keep the ringgit more broadly stable and to avoid uncertain currency swings which could harm export

1.2 Problem Statement

Inflation is the controversy issue in world economic development. It causes many others problem to the Malaysia even the country all to the world. It is because the inflation is not only burden to that country, but it also spread the effect to the related country that has relation with them. Not even one single country can avoid the inflation can happen. It always happens but the increasing of inflation can cause others problem worsens. It is the phenomenon that has features of world wide. It affected that not conclude only to certain country. It always happens to most country in the world.

Inflation also spread from the host to others, start from the primary country such as USA if they experience the inflation, then other country also experience it in the various degree of stages. When the inflation happens, it involved each part of the community. Household, workers, investor, and even pensioner affected by the inflation. But the effect is also various, certain people get the benefit from it and the others get the losses. It depend on how the money use to us, either it been use to pay debt or to pay goods we buy. Therefore, the long-run path of economic growth is one of the central questions of economics, despite some problems of measurement; an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. There is some question: how low should inflation be? In other words, is there a level of inflation at which the relationship between inflation and economic growth becomes positive?

There have been a number of formal empirical attempts to identify threshold level in the inflation growth relationship. These include, for instance, paper by Ghosh and Phillips (1998), Sarel (1996), and Khan and Senhadji (2001). These studies generally found that for economies with initially low rates of inflation, modest increases in the rate of inflation do not affect long-run rates of real economic growth. But for economies with initially high rates of inflation, further increases in the inflation rate have adverse effects on real economic growth.

During developing this study, we have brought out some of the question which related to Malaysia inflation and its economy growth. The questions that we carry out are:

What the impact of inflation in economic growth is?

Whether it affects Malaysia’s economy positively or negatively?

Does inflation affect economic growth or does economic growth affect inflation in Malaysia?

Whether there is any threshold level of inflation in the case of Malaysia above which affects growth rate of GDP different than at lower inflation rate?

1.3 Research Objectives

The aim on this study is to develop a research to test is there any effect that the inflation brings to the Malaysia economic growth.

1.3.1 General Objective

Our general objective of this study is to determine the relationship between Malaysia’s inflation rate and its economic growth. In addition, we want to know the effects bring by the inflation to Malaysia economic growth whether it is positively or negatively affected. Moreover, we examine whether there is unilateral or bilateral causality relationship between inflation rate and economic growth in Malaysia.

1.3.2 Specific Objective

Other than that, our specific objective is to estimate precise the threshold level of inflation in Malaysia. The consensus that moderate helps in economic growth, led to interesting policy issue of how much inflation is too much.

1.4 Significant of the Study

Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient’s chart prior to operating. Chances are that we have some concept of what they mean and how they interact, but what do we do when the best economic minds in the world can’t agree on basic distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle. Individual investors need to find a level of understanding that assists their decision-making without inundating them in piles of data. Find out what inflation and GDP mean for the market, the economy and your portfolio.

Many people think that inflation is bad, but this is not necessarily so. Inflation affects different people in different ways. And its effects also depend on whether inflation is expected or not. If the inflation rate corresponds to what the government is expecting (known as anticipated inflation) then people can compensate and the cost is not high. For example, workers can negotiate contracts that include automatic wage hikes as prices rise.

There is a certain types of businesses have some degree of natural protection from inflation, allowing you to maintain your purchasing power if you invest in them. Although not always possible, it’s the firms that sell things that have the easiest time passing on higher prices to customers and recouping their investment

Maintaining a low and stable inflation rate has become one of the challenges in the macroeconomic management of most countries. Among others, Malaysia has a very unique experience in terms of inflation. The inflation rate is typically measured by using an inflation index. The most popular inflation index is the Consumer Price Index (CPI).

1.5 Chapter layout

This research project consists of those following topic. The remainder of this paper proceeds as follows. Chapter 1 stated the introduction of this research project topic. In this topic, it consist the research background, problem statement, the objectives of develop this project, research questions, hypothesis of study and the significant of study. Chapter 2 is the part of literature review. All the relevant journal articles that we have study will briefly explain in this chapter. Chapter 3 presents the methodology. This topic consist introduction, research design, data collection methods, sampling design and the constructs measurement. Chapter 4 describes the data analysis. This chapter consist the introduction of the data analysis, the descriptive analysis, scale measurement, inferential analyses, and the conclusion that we make after finish the data analysis. Chapter 5 refers to the discussion, conclusion and implication about the whole research project that we develop.