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 Chapter 2

Macroeconomic Policies
Eu-Chye Tan

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 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

 Macroeconomics policies: fiscal, monetary and

exchange rate policies.
 Traditionally fiscal and monetary policies are
referred to as demand management policies with
variations in such policies affecting domestic
macroeconomic variables such as output,
employment and inflation.
 These policies could also affect the exchange rate
of a country’s currency and external payments
balance position.

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 Malaysia is a very open economy - very much influenced by
international trade and capital flows.
 An open economy is an economy in which there
are economic activities between the domestic community and
outside. People and even businesses can trade in goods and
services with other people and businesses in the international
community, and funds can flow as investments across the border.
 Fiscal authority will be more obsessed with the attainment of high
economic growth and low employment.
 Based on the Phillips curve analysis, a trade-off exists between
inflation and unemployment. Thus, high economic growth or low
unemployment and price stability or low inflation are conflicting
objectives.
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 2.1 Fiscal Policy
 Fiscal policy may be pursued in an activist or
discretionary manner in respect of its stabilization
role in the economy.
 In the event of a negative aggregate demand shock
to the economy. Government may increase the
expenditure and /or reducing the taxes. Similarly,
the overheating effect of a positive shock to
aggregate demand may be moderated by trimming
government expenditure and/or raising the taxes.

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  Fiscal policy may also be passively pursued, acting
as an automatic stabilizer of the economy. In an
economic upswing, a government’s budget surplus
would register an increase or a budget deficit would
be shrunk by an increase in tax revenue due to the
floating economic. This would moderate the
economic expansion.
 In an economic downturn, a government budget
surplus would shrink or a deficit would expand due
to falling tax receipts. This would curb the severity of
the economic downsizing.
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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 more on infrastructure
development and/or providing fiscal incentives to
firms to motivate them to invest in this sector.
 This could promote employment and
alleviate/reduce poverty.

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 2.1 Fiscal Policy (cont.)

 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 derailed which causes further
economic hardships to the public.
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 2.1 Fiscal Policy (cont.)

 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 drag is a concept where inflation and earnings
growth may push more tax payers into higher tax.
Therefore fiscal drag has the effect of raising
government tax revenue.
 This fiscal drag has the effect of reducing Aggregate
Demand and becomes an example of deflationary
fiscal policy. It could also be viewed as an automatic
fiscal stabiliser because higher earnings growth will
lead to higher tax and therefore moderate
inflationary pressure in the economy.
 .
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 2.1 Fiscal Policy (cont.)

 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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 2.1 Fiscal Policy (cont.)
 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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 2.1 Fiscal Policy (cont.)

 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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 2.1 Fiscal Policy (cont.)
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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 2.1 Fiscal Policy (cont.)
 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 (ricardian equivalance is an economic
theory that suggests when a government tries to stimulate an economy
by increasing deb-financed government spending, demand remains
unchanged)
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 2.2 Monetary Policy

 The Central Bank is responsible for the

administration of monetary policy
 Monetary policy objectives include strong
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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The CENTRAL BANK OF MALAYSIA (Malay : Bank
Negara Malaysia ), abbreviated BNM, is the Malaysian
central bank . Established on 26 January 1959 as the
BANK NEGARA MALAYA, its main purpose is to issue
currency, act as banker and adviser to the government of
Malaysia and regulate the country's financial institutions,
credit system and monetary policy. Its headquarters is
located in Kuala Lumpur.

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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
 Generally, monetary stability could be maintained by
ensuring that the growth in money supply is just
adequate to accommodate real growth in economy.

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 2.2 Monetary Policy (cont.)

 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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 Definition of M0, M1, M2, M3, M4
Different measures of money supply. Not all of them are
widely used and the exact classifications depend on the
country. M0 and M1, also called narrow money, normally
include coins and notes in circulation and other money
equivalents that are easily convertible into cash. M2
includes M1 plus short-term time deposits in banks and
24-hour money market funds. M3 includes M2 plus longer-
term time deposits and money market funds with more
than 24-hour maturity. The exact definitions of the three
measures depend on the country. M4 includes M3 plus
other deposits. The term broad money is used to describe
M2, M3 or M4, depending on the local practice
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 Table 2.2 Rates of growth of monetary aggregates and GDP in real terms (%)

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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)
The instruments:
1. Statutory reserve ratio
Banking institutions are required to deposit a small
percentage of the deposits they gather from the public as
non-interest yielding reserves with the Central Bank. The
cost of maintaining these reserves is borne by borrowers via
a higher lending rate.
2. Minimum liquidity ratio
It is mandatory for banking institutions to observe some
minimum liquidity ratio to ensure their liquidity at all times to
meet deposit withdrawal demands

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3. Centralization of Government and Employees
Provident Fund Deposits with the Central Bank
In times of tight liquidity and of the need to prop up
economic activity, the Central Bank could channel
these deposits to the banking system. The cash
reserves of banking institutions would then expand,
thus augmenting their lending capacity.

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4. Open market operations
They involve the purchase and sale of government
securities by the Central Bank in the open market
that would affect the reserves of banks and hence
the flow of credit and money in the banking system.
• If there is a need to boost liquidity in the economy,
the Central Bank could purchase government
securities from the banking institutions thus
enchancing the availability of loanable funds to the
public.
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 2.2 Monetary Policy (cont.)

5. Direct borrowing or lending operations

Given the limited viability of open market
operations, money market operations have also
been conducted via borrowing and lending in the
inter-bank market.
6. Discount operations
The central bank could influence liquidity and its
cost by varying the terms and conditions under
which banking institutions have temporary access
to its credit facilities.
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 7. Limits on swap transactions with foreign
customers
Swap transactions which commercial banks
could engage with offshore banks constitute an
avenue for the former to acquire ringgit of
foreign currency funds. In order to regulate
capital inflows and outflows, a maximum limit
has been set by the Central Bank on such
transactions.

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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)

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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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)

 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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 2.2 Monetary Policy (cont.)

 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

 Generally prior to the assumptions of the role as the

sole currency-issuing authority by the Central Bank
in June 1967, the exchange rate of the Malaysian
dollar was fixed at 2s.4d. Sterling.

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In 1837 the Indian rupee was made the sole official currency
in the Straits Settlements, but in 1867 silver dollars were
again legal tender. In 1903 the Straits dollar pegged at two
shillings and four pence (2s. 4d.), was introduced by the
Board of Commissioners of Currency and private banks were
prevented from issuing notes. Since then, the continuity of
the currency has been broken twice, first by the Japanese
occupation 1942 – 1945, and again by the devaluation of the
Pound Sterling in 1967 when notes of the Board of
Commissioners of Currency of Malaya and British
Borneo lost 15% of their value.

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 The Straits Settlements were the collection of four
distinct colonies, each acquired for its naval and
commercial possibilities and opportunities. The
respective settlements were Penang (1786), Malacca
(1795), Singapore (1819) and finally Labuan (1907).
They each allowed for commercial and naval shipping
to take advantage of the rich spice and trading
opportunities in the area. They were initially controlled
by the English East India Company before being
transferred to the British Crown Colony.

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  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.
 The main reason advanced by the Central Bank for
floating was that it had become evident that the fixed
exchange rate regime was no longer conducive to the
attainment of external equilibirium without any
involvement of a trade-off to domestic balance.
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  It was hoped that floating would grant the authorities
some control over the money supply and hence
management of economic activity apart from the
conception that it would to some extent insulate the
domestic price level which was rising at an alarming
rate from foreign inflation.

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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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 2.3 Exchange Rate Policy (cont.)

 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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 2.3 Exchange Rate Policy (cont.)

 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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 2.3 Exchange Rate Policy (cont.)
 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
 Increased risk in international trading of goods and
capital
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 END
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