Monetary Policy and Implementation in the Economy

MASTER IN BUSINESS ADMINISTRATION 2014

ECONOMIC ANALYSIS 740

Title : Monetary Policy and Implementation in the Economy
EmyJuita Hj Ismail 2013619036501
Farah Nadiah Ibrahim 2013812912
Norsaniah Omar 2013673956
Tengku Shahrizanny Tengku Abdullah 2013444102

Prepared for:
Prof Safri B. Ya

Monetary Policy and Implementation in the Economy

Table of Content
1.0 Abstract
2.0 Introduction
3.0 Objectives of monetary policy
4.0 Importance of monetary stability
5.0 Instruments of monetary policy
6.0 Channels of monetary policy transmission
7.0 Surface on economic growth and labor market in Asia and Malaysia
7.1 Surface on economic condition in Malaysia
8.0 How government overcome financial crisis
9.0 Case study on inflation and unemployment issues regarding to interest rate in
Malaysia
10.0 Conclusion
11.0 References

1.0

Abstract

Monetary Policy and Implementation in the Economy

The Central Bank of Malaysia keeps control on the supply of money to attain the
objectives of its monetary policy. Regarding to the Business Times, Tuesday, March 19,
2014, Bank Negara Malaysia will continue to support the growth of Malaysian economy
and help in the rate of inflation and financial imbalances. The continued low interest
rates will lead to an increase in financial imbalances. Although it has some
improvements in the economy but it still remain uncertainty. In 2014, an increasing in
price pressure, rising inflationary expectations and excessive wage increases, if they
occur, they will lead to the risk of inflation. So that, we will look into how central bank
will take actions in order to maintain the growth of Malaysia economy.

2.0

Introduction

Monetary policy is defined as the action by which the government, central bank, or other
regulatory committee determine the size and growth rate of the money supply, which
affected the interest rates, by controlling the supply of money, availability of money, and
the cost of money or interest rate in achieving economic growth and stability. It is also
known as credit policy. There are several questions that related to the monetary policy
that should be thinking of:

How much should be the supply of money in the economy?

How much should be the ratio of interest?
How much should be the viability of money?

From these questions, it shows that what the monetary policy all about is. We can say
that it is related to the demand and supply of money.
According to Prof Harry Johnson:
"A policy employing the central banks control of the supply of money as an instrument
for achieving the objectives of general economic policy is a monetary policy."
According to A.G. Hart:

Monetary Policy and Implementation in the Economy

"A policy which influences the public stock of money substitute of public demand for
such assets of both that is policy which influences public liquidity position is known as a
monetary policy."
Monetary policy also can be classified as expansionary and contractionary policy, where
expansionary policy increases the total supply of money in the economy more rapidly
than usual, and contractionary policy expands the money supply more slowly than usual
or even shrinks it. Expansionary policy is traditionally used to prevent unemployment in
a recession by lowering interest rates in the hope that easy credit will entice businesses
into expanding, whereas, contractionary policy is intended to reduce inflation in order to
avoid the resulting distortions and deterioration of asset values.
In other words, monetary policy rests on the relationship between the interest rates in
an economy, that is the price at which the money can be borrowed, and the total supply
of money. Where there is a regulated system of issuing currency through banks which
are tied to central bank, the monetary authority has the ability to alter the money supply
and thus influence the interest rate, to achieve the policy goals. Hence, economic
growth, inflation, exchange rates with other currencies, and employment will be
affected.
In Malaysia, The Central Bank of Malaysia is in charge of monetary policy, which is one
of the ways to control economy. If the supply of money increase, the rate of inflation will
increase; if the growth of the money supply is slowed too much, then economic growth
may also slow. In general, The Central Bank of Malaysia sets inflation targets that are
meant to maintain a steady inflation of three percent (3%) to four percent (4%) in 2014.

3.0

Objectives of monetary policy

Monetary Policy and Implementation in the Economy

In regarding to the research, money policy had several purposes for the country
economic growth which are to develop certain aspects:
1. Rapid economic growth
In order to make the economy of the each country growth in a good
achievement, monetary policy plays an important role to control the interest rate
and its impact on investment. By reducing interest rate, the investment level in
the economy can be encouraged. The increasing in investment will lead to a
rapid economic growth. Monetary policy also is responsible to maintain income
and price stability in the economy so that the faster economic growth can be
achieved.
2. Price stability
Inflation and deflation cannot be avoided. The price instability will be occurring.
From that, monetary policy will help to solve inflation and deflation with trying to
keep the value of money stable by reducing the income and wealth inequalities.
a. When inflation occur, Bank Negara Malaysia will use dear money
policy to control extra liquidity from the market to avoid inflation from
continues to spread. Money will be blocked by Bank Negara Malaysia to
avoid inflation and raising price. It is about not easy to get the money. It is
costly. Government makes it hard to get money through loans so that
there is less money in the hands of people and thus their purchasing
power is contained. When more money that people has so, they will buy a
lot. But, the supply of the goods is less in the market. The price of goods
and services will increase due to a lot of money and people willing to pay
more.

b. When deflation occurs, Bank Negara Malaysia will use easy money
policy to encourage investment and economy growth. Usually, according
to the policy, it will decrease interest rate paid by bank to borrow money
as a way to increase economy activity. Lower bank borrowing rate will

Monetary Policy and Implementation in the Economy

lead customer borrowing that can increase demand for the goods and
services.
3. Exchange rate stability
Monetary policy also plays an important role towards exchange rate. Foreign
population will lose confidence in our economy if the exchange rate is not stable.
So, from that monetary policy aims to maintain stability in the exchange rate.
4. Balance of payment equilibrium
The disequilibrium always occurs when there is surplus and deficit in balance of
payment. The surplus in balance of payment will reflects an excess money
supply in the domestic economy while the deficit will make stringency of money.
So, from that monetary policy will take responsibility to maintain the equilibrium in
order to achieve it.
5. Full employment
In a country there will be unemployment. Full employment is difficult to achieve.
Monetary policy can be used for achieving full employment. If the monetary
policy is expansionary then credit supply can be encouraged. It could help in
creating more jobs in different sector of the economy. As we all know, the
purpose of expansionary is to avoid unemployment by decrease in interest rate
in order to make easy credit.

6. Neutrality of money
The role of money is not just to make exchange but it is more than that. Monetary
policy should regulate the supply of money. The change in money supply creates
monetary disequilibrium. Thus monetary policy has to regulate the supply of
money and neutralize the effect of money expansion.
7. Equal income distribution
Monetary policy can help and play a supplementary role in attainting an
economic equality. Monetary policy can make special provisions for the neglect
supply such as agriculture, small-scale industries, and village industries and then

Monetary Policy and Implementation in the Economy

provide them with cheaper credit for longer term. Monetary policy can help in
reducing economic inequalities among different sections of society.

4.0

Importance of monetary stability

Central bank is responsible to maintain monetary stability. Monetary stability is refers to

the stability of the value of the Malaysian currency which is the ringgit. In order to get
the stability, the inflation should be in low degree. Inflation and deflation might be occur
when the monetary is instable. It will effect the economic growth.
When inflation happen in the market, people will be careful to use their money. They
will prefer to look for the valuable things to buy such as houses and properties. Inflation
makes people fussy in their consumption. They are likely to not save their money in
cash value due to the value that will be reduced. Reduction in the purchase takes place
and living standards declined. Exports activity also will be more expensive to foreigners
and this would reduce the competitiveness of the exports.
When deflation takes place, price is decrease and profit also decline. Company may
reduce their costs by cutting expenditure and laying off staff. Workers in turn would
have less money to spend and thus reduce spending, resulting in a further reduction in
the demand for goods and services.
But when price is stable, saving and investment will be more guaranteed. Increased
investment leads to an increase in the productive capacity of the economy and
increased economic activity leads to new job creation.
Central bank conducts its monetary policy by influencing the level of interest rates that
borrowers have to pay on their loans and that depositors earn on their deposits. When
the economy is facing inflation, monetary policy will be tightened by withdrawing funds
from the banking system and raising interest rates. The higher interest rates will
encourage people to save more and spend less. It would also make it more expensive
for people to borrow money. This will cause consumption and investment to slow down
to a level that is more sustainable and reduce the prospect for high inflation.

Monetary Policy and Implementation in the Economy

Besides that, when economic conditions are weak, funds will be injected into the
banking system to reduce interest rates. With lower interest rates, spending and
borrowing would increase. The resulting increase in consumption and investment would
stimulate further economic activity, leading to higher income, employment and
economic growth.
5.0

Instruments of monetary policy

There are several instruments of monetary policy used by central bank, depending on
the level of economic development, especially the financial sector. The first instrument
that is commonly used by the central bank is reserve requirement. The central bank
may require Deposit Money Banks to hold a fraction or a combination of their deposit
liabilities (reserves) as vault cash or deposits with it. The fractional reserve will limit the
amount of loans that banks can make to the domestic economy, and, thus limit the
money supply. The assumption is that Deposit Money Banks generally maintain a stable
relationship between their reserve holdings and the amount of credit they extend to the
public.

During inflation, commercial banks can buy treasury bills with excess reserves
and do not have to reduce the amount of time deposits so that the money supply
in the economy is not reduced. Finally the bank rate hike policy and operational
sell treasury bills or government bonds in the open market will fail.

During deflation, the ratio of reserves (statutory and liquid assets) should be
lowered by the central bank to increase the ability of commercial banks to
provide credit and therefore to increase the investments in the country. Finally,
the money supply in the economy improves and deflation can be overcome.

The second instrument of monetary policy is open market operations. The central
bank buys or sells securities to the banking and non-banking public, that is in the open

Monetary Policy and Implementation in the Economy

market. One such security is Treasury Bills. When the central bank sells securities, it
reduces the supply of reserves and when it buys the securities back, by redeeming
them, it will increase the supply of reserves to the Deposit Money Banks, thus affecting
the supply of money.

During inflation, money supply in the economy should be reduced. The central
bank will sell treasury bills or government bonds to commercial banks and the
public. With this, the money held by the commercial banks and the public is
reduced, thus the amount of money that can be spent on the transaction can be
reduced as well, inflation finally overcomes.

During deflation, the money supply in the economy should be added. The central
bank will buy Treasury bills or government bonds from commercial banks and the
public. With this, the money held by the commercial banks and the public
increases, thus the amount of money that can be spent on the transaction can be
improved as well, eventually overcome deflation.

The other instrument of monetary policy commonly used by the central bank is interest
rate, where the central bank lends to financially sound Deposit Money Banks at a most
favorable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the
floor for the interest rate regime in the money market, the nominal anchor rate, and
thereby affects the supply of credit, the supply of savings (which affects the supply of
reserves and monetary aggregate) and the supply of investment (which affects full
employment and Gross Domestic Product, GDP).

During inflation, the central bank will raise interest rates to raise the cost of loans
granted by commercial banks to their borrowers. This is to reduce the borrower's
ability to do business, this causes reduced aggregate demand and thus lower the
general price level, inflation is finally resolved.

Monetary Policy and Implementation in the Economy

During deflation, the central bank will lower interest rates to reduce the cost of
loans granted by commercial banks to their borrowers. This is to increase the 10
ability of the borrower to perform the transaction, this causes increased
aggregate demand and thus increase the level of employment, deflation finally
resolved.

Besides, exchange rate is also one of the monetary policy instruments commonly used
by the central bank. In the selling or buying foreign exchange, the central bank will
ensure that the exchange rate is at levels that do not affect domestic money supply in
undesired direction, through the balance of payments and the real exchange rate. The
misaligned real exchange rate will affect the current account balances as its impact on
external competitiveness.
The qualitative instrument of monetary policy that is commonly used by the central bank
is moral suasion. The central bank issues licenses or operating permit to Deposit
Money Banks and also regulates the operation of the banking system. From this
advantage, it can persuade banks to follow certain paths such as credit restraint or
expansion, increased savings mobilizations and promotion of exports through financial
support, which otherwise they may not do, on the basis of their risk ore return
assessment.

During inflation, the central bank will persuade commercial banks to reduce the
amount of loans for speculative purposes.

During deflation, the central bank will persuade commercial banks to increase
the amount of loans for speculative purposes.

Other than that is consumer credit regulation. Under this method, consumer credit
supply is regulated through hire-purchase and installment sale of consumer
goods. Under this method the down payment, installment amount, loan duration,
etc is fixed in advance. This can help in checking the credit use and then inflation
in a country.

Monetary Policy and Implementation in the Economy

During inflation, the central bank will stop people from buying the vehicle
on installment credit by increasing the minimum down payment, reducing 11
the amount of credit loan and shorten the payback period of installment
credit; this will reduce the ability of people to buy vehicles on credit
installments.

During deflation, the central bank will encourage people to buy vehicles on
credit installments by lowering the minimum payment rate, increasing the
credit amount and extend the loan repayment installment credit; this will
increase the ability of people to buy vehicles on credit installments.

Central bank also uses fixing margin requirements method. The margin refers to the
proportion of the loan amount which is not financed by the bank. A change in a
margin implies a change in the loan size. This method is used to encourage credit
supply for the needy sector and discourage it for other non-necessary sectors.
This can be done by increasing margin for the non-necessary sectors and by
reducing it for other needy sectors.

During inflation, the central bank will stop people from buying stocks for
speculative purposes by raising margin requirements to reduce the loan
amount allowed by speculators.

During deflation, the central bank will encourage people to buy the shares
for speculative purposes by lowering margin requirements in order to
increase the loan amount allowed by speculators.

6.0

Channels of monetary policy transmission

Monetary transmission is referred to the process through which monetary policy action
is transmitted into economy. There are several channels of monetary policy
transmission, but functioning and effectiveness of these mechanisms vary across
countries due to differences in the extent of financial intermediation, the development of
domestic capital markets, and structural economic conditions.

Monetary Policy and Implementation in the Economy

The first channel of monetary policy transmission is the interest rate channel, operates
through the impact of monetary shocks on liquidity conditions and real interest rates,
which in turn affect interest rate sensitive components of aggregate demand such as
consumption and investment. Although the interest rate channel is the long-established
mechanism of monetary transmission, it may not account for the full extent of output
fluctuations, particularly in a small open economy.
The bank lending (or credit) channel is the second channel of monetary policy
transmission, which works through the response of credit aggregates to changes in
interest rates and other policy instruments. Therefore, the credit channel is an extension
and an enhancement mechanism to the interest rate channel and amplifies the real
effects of monetary policy through changes in the supply of bank credit. The necessary
condition for the credit channel to operate is the significant role of banks as a source of
capital for the private sector, especially in bank-based emerging market economies.
The third one is the exchange rate channel, works through the impact of monetary
developments on exchange rates and aggregate demand and supply. For example, an
increase in interest rates would normally lead to an appreciation of the exchange rate,
which lowers the price of imported goods and services and thereby pushes down
domestic inflation. The effectiveness of the exchange rate channel depends on the
exchange rate regime, the extent of exchange rate pass-through and the degree of
openness to capital flows. In a small open economy with a flexible exchange rate
regime, the exchange rate channel is typically an important transmission mechanism for
monetary policy actions. Alternatively, when the exchange rate is fixed, domestic
interest rates track foreign interest rates, leaving little or no room for domestic monetary
policy.
The other channel of monetary policy transmission is the balance sheet channel,
which operates through the impact of monetary innovations on the net wealth and credit
worthiness of household and companies. In other words, like the bank lending channel,
wealth effects influences consumption demand through changes in real money
balances of households and firms that rely on borrowed funds.

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Monetary Policy and Implementation in the Economy

Next, the asset price channel operates through the impact of monetary shocks on
yields, equity shares, real estate, and other domestic assets, operating through
changes in the market value of corporate and household wealth. Changes in short-term
interest rates or other policy instruments can alter firms capacity for fixed investment
spending through balance sheet effects, and household consumption through wealth
effects.
The last channel of monetary policy transmission is the expectations channel, which
works through the impact of monetary shocks on the perception of households and
firms about inter temporal rates of substitution. Inflation expectations, for example, play
a pivotal role by influencing interest rates, exchange rate movements, wages,
aggregate demand, and domestic prices.

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Monetary Policy and Implementation in the Economy

In the simple way, we can simplify the effect from the channels towards economy in
general and the price level.

14

Change in official interest rates

The central bank provides funds to the banking system and charges interest. Given its
monopoly power over the issuing of money, the central bank can fully determine this
interest rate.

Affects banks and money-market interest rates

The change in the official interest rates affects directly money-market interest rates and,
indirectly, lending and deposit rates, which are set by banks to their customers.

Affects expectations

Expectations of future official interest-rate changes affect medium and long-term

interest rates. In particular, longer-term interest rates depend in part on market
expectations about the future course of short-term rates. Monetary policy can also guide
economic

agents expectations

of

future

inflation

and

thus

influence

price

developments. A central bank with a high degree of credibility firmly anchors

expectations of price stability. In this case, economic agents do not have to increase
their prices for fear of higher inflation or reduce them for fear of deflation.

Affects asset prices

The impact on financing conditions in the economy and on market expectations

triggered by monetary policy actions may lead to adjustments in asset prices
such as stock market prices and the exchange rate. Changes in the exchange
rate can affect inflation directly, insofar as imported goods are directly used in
consumption, but they may also work through other channels.

Affects saving and investment decisions

Changes in interest rates affect saving and investment decisions of households and
firms. For example, everything else being equal, higher interest rates make it less

Monetary Policy and Implementation in the Economy

attractive to take out loans for financing consumption or investment. In addition,
consumption and investment are also affected by movements in asset prices via wealth
effects and effects on the value of collateral. For example, as equity prices rise, shareowning households become wealthier and may choose to increase their consumption.
Conversely, when equity prices fall, households may reduce consumption. Asset prices
can also have impact on aggregate demand via the value of collateral that allows
borrowers to get more loans and/or to reduce the risk premia demanded by
lenders/banks.

Affects the supply of credit

For example, higher interest rates increase the risk of borrowers being unable to pay
back their loans. Banks may cut back on the amount of funds they lend to households
and firms. This may also reduce the consumption and investment by households and
firms respectively.

Leads to changes in aggregate demand and prices

Changes in consumption and investment will change the level of domestic demand for
goods and services relative to domestic supply. When demand exceeds supply, upward
price pressure is likely to occur. In addition, changes in aggregate demand may
translate into tighter or looser conditions in labour and intermediate product markets.
This in turn can affect price and wage-setting in the respective market.

Affects the supply of bank loans

Changes in policy rates can affect banks marginal cost for obtaining external finance
banks differently, depending on the level of a banks own resources, or bank capital.
This channel is particularly relevant in bad times such as a financial crisis, when capital
is scarcer and banks find it more difficult to raise capital. In addition to the traditional
bank lending channel, which focuses on the quantity of loans supplied, a risk-taking
channel may exist when banks incentive to bear risk related to the provision of loans is
affected. The risk-taking channel is thought to operate mainly via two mechanisms.
First, low interest rates boost asset and collateral values. This, in conjunction with the

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Monetary Policy and Implementation in the Economy

belief that the increase in asset values is sustainable, leads both borrowers and banks
to accept higher risks. Second, low interest rates make riskier assets more attractive, as
agents search for higher yields. In the case of banks, these two effects usually translate
into a softening of credit standards, which can lead to an excessive increase in loan
supply.

The effectiveness of monetary policy transmission mechanism varies and evolves over
time, depending on structural economic and financial conditions. Although monetary
policy transmission channels have distinctive effects on the real economy, there are
also possible interlink ages between the channels through which they may magnify or
counteract the influence of other channel in the monetary transmission process.
7.0

Surface on economic growth and labor market in Asia and Malaysia

The labor market is the most important components of economic transition which occurs
in rural and urban areas. The early stages of Malaysia and Asia economy started from
the rural area (agricultural and mining sector).Transformation of this rural area economy
to urban areas since 1990s to manufacturing and services sectors which created job
and opportunities in the urban area. As the economy is growing, there is an increased
competition among nations where greater labor market flexibility and good jobs need to
be created in achieving globalization.

The Gross Domestic Product (GDP) rate in

Malaysia averaged high in all time from 2000 until 2012. The growth of population
grows faster than the employment opportunities generated in the market. Affected by it
are the low rate of unemployment in Malaysia which are large corporate buffer and the
presence of foreign labors.
Migration is the biggest threatened to Malaysia economy. There are significant numbers
of workers which migrate abroad especially high and educated people. Their migration
is due to the high demand and better job opportunities from abroad for particular skills
and professions. This large population of skilled migrate works for particular profession

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Monetary Policy and Implementation in the Economy

will discourage investment and slow down the economic growth of a country.
Government should take this problem into consideration and resolve with a thoughtful
way to encourage the local labors work and contribute to their own country. This will
avoid job outsourcing to other countries as well.

7.1

Surface on economic condition in Malaysia

As we all know, Malaysian are divided into three groups according to ethnicity which are
Indian, Chinese and Malay. During the colonial rule, British introduced palm oil and
rubber trees for commercial purposes. British also allowed the migration of Chinese and
Indian to work under mines and plantation sectors in Malaysia. In this case, the British
colonial system at the early years has eventually divided Malaysian into three groups
according to ethnicity. The Malays living in a poor condition because they are more
focused in their traditional villages which are their incomes are mainly focused on the
agriculture activities. The Chinese were dominating the Malaysian commerce while
Indians focused on their plan activities. Somehow, educated or Malay nobleman at that
time was given the chance to enjoy a better social life served as civil servants under the
British colonial system. Later Malaysia Five Year Plan was introduced in the year 1955
just after independence to reduce poverty and increase per capita income and living
standards of the country. However, after the First and Second Malayan Plan, the plans
had transformed Malaysia to an emerging multi-sector economy. Moving forward to
2020, Malaysia had investing in high technology industry, biotechnology, services and
Islamic finance.
Malaysia should continue to increase the amount of demand and reduce the reliance of
imports. Besides, Malaysia should increase the amount of exports because they acted
as the important components to boost the economy growth. The exports of Malaysia
include electronics, palm oil, oil and gas and rubber. In 2012, Malaysias economy is
growing at a steady pace of 4% to5% and cover governments fund of 40%. The

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Monetary Policy and Implementation in the Economy

domestic demand and consumption are growing at 7% whereas the investment is
growing at 10%. The domestic demand, consumption and investment act as the main
drivers of an economic growth.
To produce crude oil, achieve low inflation and well capitalized a stable banking system;
Economic Transformation Program (ETP) had allowed Malaysia to achieve the
developed nation status by 2020 with stronger value-added industries and services,
higher incomes and less reliance on inconstant goods earnings. For example, support
domestic demand and boost up the consumer confidence which include providing
benefit for the poor, tax reduction and bonuses for public sector workers.
8.0

How government overcome financial crisis

Monetary policy plays an important role during financial crisis. An increasing frequency
after the advent of financial liberalization and deregulation in the 1970s lead to the
financial crisis. Between 1970s and 2007, there have been 124 banking and financial
crisis worldwide, compared to the infrequency of such crisis when banking was
regulated and capital flows were controlled from 1940s to 1970s. The Asian Financial
Crisis in 1997 came as a surprise and caught most people by surprise not only by the
speed but also the severity of the crisis. Malaysia and other Southeast Asian countries
experienced their worst financial crisis from 1997 to 1999 as a result of financial
deregulation. International Monetary Funds (IMF) and the United States government
pushed for liberalization of capital accounts and banking sectors in developing
countries.
Unregulated capital flows and pegged exchange rates brought an increment in capital
flows into Southeast Asian economies taking advantage of arbitrage opportunities.
Malaysia was not excluded even its external debt burden was not too much. In 1997,
the ringgit value goes down from RM2.40 to a low of RM4.90 to US$1. Net portfolio
investment shrunk RM22 billion, from positive RM10.3 billion in 1996 to negative
RM12.9 billion in 1997. This led to a collapse of the stock market, the ballooning of
foreign debt, massive corporate defaults and non- performing loans resulting in a
banking crisis. Malaysia did not apply for any IMF assistance due to the relatively low

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Monetary Policy and Implementation in the Economy

level of foreign indebtedness. Nevertheless, it followed the standard IMF prescription in
facing the crisis.

On the macro-economic policy front, it raised interest rates with the view of stemming
capital outflows, the currency was floated to allow for free capital flows, and it reduced
public expenditure by 18%. On the financial sector side, it changed the definition for
non-performing loans from 6-months arrears to 3-months arrears. Unfortunately, with
the implementation of these policies, what started as a financial and currency crisis,
soon became a full-blown economic crisis. Aggregate domestic demand declined in
1998 for the first time since 1986, due to a significant negative contraction in private
investments by 55% and private consumption by 10%. The real economy contracted
14%, with GDP growth plunging from positive 7.7% in 1997 to negative 6.7% in 1998.
The stock market plummeted by over 70% and the ringgit fell to its lowest of RM4.9 to
US$1 in January of 1998.
By early 1998, it was clear the IMF macro-economic policies of pro-cyclicality were not
working. Dr. Mahathir, then Prime Minister of Malaysia, changed direction, set up the
National Economic Action Council and centralized decision-making and policies. In July
1998, he launched the National Economic Recovery Plan that was seen as an
alternative to the IMF orthodox policies. The objectives of this plan were to stabilize the
local currency, restore market confidence, maintain financial markets stability,
restructure corporate debt, recapitalize and restructure the banking sector and revitalize
the economy. These policies were implemented in stages.
To counter the recession, on the monetary and financial sector front, Bank Negara
reduced interest rates gradually from 11% in July 1998 to 6% May and 3% in December
1999. The statutory reserve requirement was also lowered from 13.5% in July to 4% by
October 1998. The non-performing loan definition was changed back to 6 months
arrears instead of 3 months. Bank Negara also set targets for banks to increase their

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Monetary Policy and Implementation in the Economy

loans to 8% by 1999. Malaysia is a highly open economy with external trade (exports
and imports) constituting over 200% of its GDP. Hence the stability of its currency is
crucial for its external trade. Prior to and during the crisis, the ringgit was traded offshore and the higher interest rates paid to off-shore ringgit deposits encouraged an
outflow of the ringgit. Mahathir banned off-shore market trading of the ringgit and gave
depositors a grace period to repatriate their off-shore ringgit deposits back to Malaysia.
At the same time in September 1998, he fixed the ringgit exchange rate to US$1 to
Ringgit 3.8. According to conventional economic theory, it is not possible for a country to
control both its interest rates (through its monetary policies) and foreign exchange rates
under a regime of free capital flows. This is because with free and unimpeded capital
flows, a lower interest rate would encourage outward capital flows and hence a lower
exchange rate, and vice versa.
This is termed the impossible trinity. See figure 3.
Figure 3: Impossible Trinity

The primary objectives of the Malaysian governments monetary and capital control
policies are to ensure stability in the ringgit-foreign exchange rate so as not to disrupt
trade flows; at the same time to maintain a steady and relatively low interest rate to
sustain economic growth. In choosing the appropriate monetary and other less
conventional instruments to achieve the above objectives, the government is guided by

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Monetary Policy and Implementation in the Economy

pragmatism and flexibility. Hence its monetary and foreign exchange rate policies have
undergone several transitions.

9.0

Case study on inflation and unemployment issues regarding to the interest

rate in Malaysia
There are two macroeconomics policies used by government to combat high inflation
and unemployment in Malaysia which known as fiscal policy and monetary policy. From
the article that we read, it tells us about the monetary policy which is an economic
attempts to relieve broad objects of policy stability of employment and prices,
economic growth and balance of payment through control of monetary system,
economic open market operation, credit multiplier, operating monetary magnitudes
control such as supply of money, level and structure of interest rates and conditions that
effect availability credit by Bank Negara Malaysia.
Monetarists agree that quantity of money supplied affects the overall price level, interest
rate, exchange rate, unemployment rate and level of output in the market. The kind of
monetary policy depends on the Malaysia situation. There are tight monetary policy
which restrain the economy and also easy monetary policy which aggressively expand
money supply and lower interest rate and also increase the investment.
The benchmark interest rate in Malaysia was last recorded at 3 percent. Interest rate in
Malaysia averaged 2.93 percent from 2004 until 2014, reaching an all time high of 3.50
percent in April of 2006 and a record low of 2 percent in February of 2009. Interest rate
in Malaysia is reported by the Central Bank of Malaysia.

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22

On 8th May 2014, Bank Negara Malaysia left the overnight policy rate unchanged at 3
percent. The central bank cited firm growth prospects and stable inflation, but hinted it
may need to tighten monetary policy in the near future to curb financial imbalances like
rising household debt.
For Malaysia, exports will continue to benefit from the recovery in the advanced
economies and regional demand. Private sector spending is expected to remain robust.
Investment activity is supported by broad-based capital spending, particularly in the
manufacturing and services sectors. Private consumption will be underpinned by stable
income growth and favorable labor market conditions. The prospects are therefore for
the growth momentum to be sustained.
In the recent months, inflation shows a good condition due to the impact of the price
adjustments for utilities and energy moderate. However, inflation is expected to remain
above its long run average due to the higher domestic cost factors. So, from that, the
monetary policy should be enhancing in order to ensure that the risks arising from the
accumulation of these imbalances would not undermine the growth prospects of the
Malaysian economy.

Monetary Policy and Implementation in the Economy

Regarding to the interest rate, we can see that the monetary inflation usually resulted in
price inflation which raised the general level of prices of goods and services which
should be sustained. The originally of the term inflation was used to refer only to
monetary inflation which presently used refers to price inflation.
The implementation of monetary policy alone was not adequate. Monetary policy will be
effective when all policies which are fiscal and monetary policy were implemented
together. Consumption spending and inflows of short term speculative capital had
emerged as important influences on the effectiveness of monetary policy. Monetary
aggregate also play an important role in this situation. In addition, the effect of monetary
policy on interest rate movements and exchange rate development could not be
ignored. Malaysia could not effort to have a higher interest rate to attract further capital
inflows. This will dampen productive investment and business. External and internal
prices stability should be maintained at all costs.
Malaysia experience had showed that implementation of monetary instruments can
achieve this balance. For each instruments, there is their own strength and weakness
which then complement each other to enhance the attainment of the desired goals.
When having high inflation, Malaysia will use dear money policy which is tight policy
that controls the money in the market. Bank Negara Malaysia expands the money
supply more slowly than usual or even shrinks it. The money will be difficult and costly
to get. Government makes it hard to get money through loans so that there is less
money in the hands of people and their purchasing power can be control. And therefore,
it will reduce inflation.

23

Monetary Policy and Implementation in the Economy

24

Inflation Rate in Malaysia 2014 : People of Kuala Lumpur did not anticipate the rise of
the inflation rate in Malaysia this year. The rise of the inflation Malaysia rate is
equivalent to 3.4 percent. This is recorded in January 2014.
Aside from this, there is also a 15 percent obvious adjustment in the electricity tariff.
According to the experts, the market expectation for the inflation rate in Malaysia is 3.3
percent. With this, there is a great difference in what has come out this year.
The inflation rate in Malaysia was recorded at 3.50 percent in March of 2014. Inflation
Rate in Malaysia averaged 3.72 Percent from 1973 until 2014, reaching an all time high
of 23.90 Percent in March of 1974 and a record low of -2.40 Percent in July of 2009.
Inflation Rate in Malaysia is reported by the Department of Statistics Malaysia.
There are different reasons that can be attributed to the rise in the inflation rate. One of
these is the rise in the manufacturing cost of the regular beverages and food. This
affected the economic value of ringgit against dollar.

Monetary Policy and Implementation in the Economy

And according to the economic experts, the rise of the inflation rate in Malaysia is not
going to end in just a month. It will continue to rise in the coming months and it is
expected that it will hit 3.8 on August. This is something that is unexpected. They are
just expecting an inflation rate in Malaysia of 3.2 for this year.

The inflation rate had contributed the fluctuations of unemployment rate in Malaysia.
The famous populous economist from Wellington, A.W Phillip appeared that in 1929,
the economic depression had impacted the raising of unemployment rate.
There are bonded between inflation rate and unemployment rate which is known if the
inflation rate is high, the level of unemployment is low. It indicates the reciprocal linkage
between inflation unemployment rates of people.
There are three types of unemployment in Malaysia which are unemployment frictional,
unemployment structural and unemployment circle cyclical.
i.

Unemployment Frictional
Raised from normal labor market turnover where people are deciding to move
among job of the people, careers options and working location. It is known as
fixed and healthy conditions which are resulted from the mismatching between
workers and jobs.

ii.

Unemployment Structural
Occurred during the changes in technology and foreign competition. It can be the
result of mismatch of skills of unemployed works and availability jobs in the
market. Seasonal employment can be part of the structural unemployment too.
Example, fishing, agriculture or construction work.

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Monetary Policy and Implementation in the Economy

iii.

Unemployment Circle-cyclical
Related to the dynamics of economic growth and factors of production in the
cycle of business. At some peak situation cyclical unemployment will be
considered lower than normal unemployment and when business cycle are at
their normal unemployment, cyclical unemployment is higher than normal
unemployment. It also arises when economic facing recession because the
market labor supply exceeds the demands from the employers due to the
widespread decreased in spending and consumption in the economy. For
example, a person lost his job during economy recession and rehired again when
the economy experiences expansion.

In order to avoid unemployment from raising, Bank Negara Malaysia will using easy
money policy which increase the total supply of money in the economy more rapidly
than usual by lowering interest rate in the hope that easy credit will entice business into
expanding.

26

Monetary Policy and Implementation in the Economy

Unemployment Rate in Malaysia decreased to 3.20 percent in February of 2014 from
3.30 percent in January of 2014. Unemployment Rate in Malaysia averaged 3.31
Percent from 1998 until 2014, reaching an all time high of 4.50 Percent in March of
1999 and a record low of 2.70 Percent in August of 2012. Unemployment Rate in
Malaysia is reported by the Department of Statistics Malaysia.
From Bernama, February 21, 2014, Malaysia will enjoy the full employment when its
unemployment rate for December last year fell to 2.9% from 3.5% a month earlier. The
unemployment rate was also lower than the 3.3% posted in the same month in 2012.
The number of employed and unemployed persons recorded a decline of 131,400 and
59,600 persons to 13.55 million employed and 425,000 unemployed persons
respectively in December last year. the labour force participation rate eased 1.3% to
13,973,800 persons in December last year from 14,164,800 persons in the previous
month.Year on year, it rose by 4.8% from 13,332,100 persons recorded in December
2012.
Another issue that we want to share too is about the effect from foreign workers who
work in Malaysia.
a. Foreign workers as competitors for local workers.
Foreign workers from Indonesia, Pakistan, Bangladesh, Iran, Yemen, Philippines and
others had created competition between the foreign workers and locals to get a job. The
presence of foreign workers has impacted to the stress of public amenities in Malaysia
such as provision of health services, public and others.
According to the case study, the trend of foreign workers increase in Malaysia is
considered as stimulator for the local people to transform them labor intensive
industries orientation toward hybrid modeled skilled industries like bank and finance
sectors, computers and technological sectors, research and development areas and
public instrument and infrastructure provision services.
b. Foreign workers as the keep stable of economic

27

Monetary Policy and Implementation in the Economy

Unemployment as damaging issue in Malaysia Economic during times of Asian Crisis,
the number of foreign workers in Malaysia has arisen up from an 850,000 people in
2001 to 1, 470, 00 people in 2004 and calculated to be 2,045,000 in 2007 and
nowadays it reaches to be 2, 7 million foreign workers. Considering that 1,000,000 of
foreign workers in manufacturing sector, which can cover up two thirds of the
manufacturing sector 1.4 million work-forces in Malaysia. Its high correlation and
presence had become the reason of Malaysias low wage architecture within last one
decade. However, the existence of foreign labor in Malaysia had successfully kept up
and managed the unemployment rate become stable and starkly even lower within last
one decade expected range of 3% to 4% annually.
The presence of more than 2.7 million workers in Malaysia had become a pertinent
issue which effected the economic growth. According to Firman Shah (2012), he had
mention the presence of foreign worker had omitting and smoothening up labor
shortages in certain areas of work in Malaysia. They had played complimentary roles to
domestic labor in covering up and fulfilling the demand for labor market in Malaysia
which help to stable the unemployment rate and fluctuates range between 2.9% to 3.6%
per year within last one decade (The Composition of Malaysia Population 2010)
For monetarist, the presence of foreign worker had given effect to the unemployed
graduates which later become a worrying trend to Malaysia. However, during financial
crisis, the total retrenched workers are total majority workers which argue the
displacement of them.

10.0

Conclusion

28

Monetary Policy and Implementation in the Economy

Monetary policy play important role to implement in economic growth by stabilizing in
influencing through a number of channels. For example in price stability, by increasing
in price level achieve is adjudged substantially to be a monetary phenomenon,
monetary policy uses its tools to effectively check money supply with a view to
maintaining price stability in the medium to long term. The expectation in economic
activities will be higher and contribute to higher consumer spending and attractive
companies investment by cut interest rate to make the cost of borrowing, resulting
higher investment activity and the purchase customer durables. The misconduct of
monetary policy will also effected inflation, unemployment, excessive foreign workers,
exchange rates, current account deficits, excessive public debt and terms of trade. This
will also lead to determine the political stability and the economic performance of a
country.
11.0

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