Tests of the different variants of the monetary model in a developing economy: Malaysian experience in the pre- and post-crisis periods

Abstract

This study examines the validity of four different variants of the monetary model of exchange rate determination for Malaysia covering both the pre- and post-crisis periods using the vector error-correction models. The findings demonstrate that for both periods, the variables used are cointegrated. Tests tend to suggest that of the four variants of monetary model, the sticky-price model holds in both periods and the flexible-price model holds only in the post-crisis period. The proportionality between the exchange rate and relative money does not hold in any period. The plotted actual and fitted exchange rates for both sub-samples show that the models are able to track the actual exchange rate trend quiet well.

Notes

¹The UIP relationship is usually invoked when domestic and foreign assets are perfect substitutes, there is no uncertainty and there is absence of capital controls and transaction costs.

²The results of unit root test and cointegration test are available in Appendix: Tables A1 and A2.

³For the post-crisis period where there are three cointegrating vectors, zero restrictions were imposed on the adjustment coefficient (α) of the second and third cointegrating vectors and the likelihood ratio failed to reject the imposition. Hence, the analyses proceed with single cointegrating vector.

⁴The results in table form are available in Appendix: Table A3.

⁵Prior to pegging of the ringgit to the USD on 2 September 1998, BNM actively intervenes in the foreign exchange market to ensure orderly market conditions and to moderate day-to-day fluctuations in the value of the ringgit (Chua and Bauer, 1995; Bank Negara Malaysia, 1999, p. 270).

⁶Explanation provided by Soon (1995) for similar result for Malaysia.

⁷These final parsimonious specifications are obtained by removing the insignificant regressors. In order to avoid mis-specification, at least one of the lag variable (with largest t-ratio) will be retained in the case of all the lagged variables are not significant.

⁸The detail of residual plots and technique used to correct non-normality are available from the authors upon request.

⁹The results are available in Appendix: Table A4.

¹⁰Forecast for exchange rates are made using the actual data for the explanatory variables.