The Impact Of Inflation On Economic Growth: Evidence Of Malaysia From .

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DECLARATIONI hereby declare that:This master thesis is the final product of my own work and has not been submittedbefore for any degree, examination or any related qualifications at any university orinstitution and ALL the sources I have used or quoted , have received dueacknowledgments as complete references.Name; SurnameHemin Tawfiq Aziz Al.taeshiSignature .Date

NEAR EAST UNIVERSITYGRADUATE SCHOOL OF SOCIAL SCIENCESEconomics Master’s ProgramThesis DefenseThe Impact of Inflation on Economic Growth: Evidence from MalaysiaWe certify the thesis is satisfactory for the award of degree ofMaster of EconomicsPrepared by Hemin Tawfiq Aziz Al. Taeshi (20145331)24th May 2016Examining Committee in ChargeAssoc. Prof. Dr.Near East UniversityDepartment of TourismManagementandHotelAssoc. Prof. Dr.Near East UniversityDepartment of Computer Education andInstructional technologyAssoc. Prof. Dr.Near East UniversityDepartment of Business AdministrationApproval of the Graduate School of Social SciencesAssoc. Prof. Dr. Mustafa SağsanActing Director

ACKNOWLEGMENTSForemost, I am gratefully indebted to the valuable supported offered to me by mysupervisor Assoc. Prof. Dr. Hüseyin Özdeşer towards the successful completing ofthis study. Deepest appreciation goes to my best friends Hemn, Majid and Nabazwho played an unwavering role as a friend and motivator during my course of study.I also acknowledge the support of my fellow academic friends at Near EastUniversity. Special appreciation goes to Dr. Younis Ali of University of Sulemanyfor his profound mentorship abilities.i

DEDICATIONThis study is dedicated to my ever caring late father and mother, my brothers Osman,Omran, Serwan, elder sister Pakhshan and to beloved wife Kany and my dear sonRand. Deepest appreciation also goes to my elder brother Osman who has played agreater role towards this milestone event.ii

ABSTRACTThe study analyses the impact of inflation on economic growth in Malaysia. Theundertaking of this study follows a series of upward trends that have been observedin Malaysia’s economic growth patterns. However such increases in economicgrowth were accompanied with almost similar increase in the inflation rate. Timeseries data from the FRBL covering the period 1970-2014. The study employed cointegration, Granger causality, variance decomposition and impulse responsefunctions techniques, and the ordinary least squares method to determine theresponsiveness o inflation to economic growth. The study established that there is along relationship between economic growth and inflation. The results of the studyalso showed that Economic growth in Malaysia has an inelastic response toinflationary pressure.Key Words: Inflation, Economic growth, Gross savings, Imports, Malaysia.iii

ŐZÇalışma Malezya’daki enflasyonun ekonomik büyümenin etkisini analiz etmektedir.Bu çalışmanın girişimi Malezya'nın ekonomik büyüme modellerinde gözlemlenen birdizi artış eğilimini izlemektedir. Ancak ekonomik büyümedeki bu gibi artışlarenflasyon oranındaki artışlara neredeyse benzer artış göstererek eşlik etmiştir.FRBL’den gelen zaman serisi verileri 1970-2014 dönemini kapsamaktadır.Çalışmada enflasyonun ekonomik büyümedeki duyarlılığını belirlemek içineşbütünleşme, Granger nedensellik, varyans ayrıştırma ve dürtü yanıtı fonksiyonlarıteknikleri ve sıradan en küçük kareler yöntemi kullanılmıştır. Çalışma, ekonomikbüyüme ve enflasyon arasında uzun vadeli bir birlik olmadığını ortaya çıkarmıştır.Çalışmanın sonuçları ayrıca Malezya'daki ekonomik büyümenin enflasyonist baskıyaesnek olmayan bir tepki verdiğini göstermiştir.Anahtar Kelimeler: Enflasyon, Ekonomik büyüme, Brüt tasarruflar, İthalat,Malezya.iv

TABLE OF CONTENTSACKNOWLEGMENTS .iDEDICATION . iiABSTRACT . iiiŐZ . ivTABLE OF CONTENTS . vLIST OF FIGURES . viiiLIST OF TABLES . ixLIST OF ABBREVIATIONS . xCHAPTER ONE . 1INTRODUCTION . 11.1 Background of Study . 11.2 Statement of the Problem . 31.3 Research Objectives . 41.4 Research Questions . 41.5 Hypothesis . 41.6 Significance of the Study. 41.7 Scope and Limitation of the Study . 51.8 Justification of the Study . 51.9 Organization of the Study . 5CHAPTER TWO . 6THEORETICAL AND EMPIRICAL LITERATURE REVIEW . 62.1 Theoretical Literature Review . 62.1.1 Classical Growth Theory . 62.1.2 Neo- Classical . 72.1.3 Neo-Keynesian . 82.1.4 Monetarism . 92.1.5 Endogenous Growth Theory . 102.1.6 Keynesian. 112.2 Empirical Literature Examining the Link between Inflation and EconomicGrowth . 122.3 Empirical Implications about Inflation and Economic Growth in Malaysia . 172.4 Inflation, Growth and Central Banks . 182.5 Sustainable Level of Inflation and Economic Growth . 192.6 Transmission Mechanism between Inflation and Economic Growth . 192.7 Chapter Summary. 21v

CHAPTER THREE . 22GENERAL OVERVIEW OF THE MALAYSIAN ECONOMY . 223.1 The Malaysian Macroeconomic Environment Outlook . 223.2 Economic Growth Patterns in Malaysia . 233.2.1 The Changing Pattern of Economic Growth. 233.2.2 The Colonial Development . 233.2.3 Post-independence Developments. 243.2.4 The Need for Economic Development . 243.2.5 Recent Trends . 243.3 Inflation Trends in Malaysia . 263.3.1 Measuring Inflation in Malaysia . 263.4 Economic Growth vs Inflation in Malaysia . 283.5 Malaysia‟s Economic Policies and Strategies . 283.5.1 Measures to Curb Inflation . 28CHAPTER FOUR . 31RESEARCH METHODOLOGY . 314.1 Introduction. 314.2 Model Specification . 314.3 Stationarity Tests. 324.4 Cointegration . 334.5 Granger Causality. 344.5 Stability Diagnostics . 354.7 Definition and Selection of Variables . 354.7.1 Gross Domestic Product (GDP) . 354.7.2 Inflation Rate (INFL) . 364.7.3 Imports (IMP) . 364.7.4 Gross Savings (GS) . 37CHAPTER FIVE . 39ANALYSIS AND INTERPRETATION OF RESULTS . 395.1 Introduction. 395.2 Stationarity Tests. 395.3 Co-integration Test . 415.4 Responsiveness of GDP to the Variables . 435.5 Variance Decomposition . 445.6 Impulse Response Function . 455.7 Granger Causality. 46CHAPTER SIX . 48vi

SUMMARY, CONCLUSIONS AND RECOPMMENDATIONS . 486.1 Introduction. 486.2 Summary of Major Findings . 486.3 Conclusions . 496.4 Recommendations . 506.5 Suggestions for Future Research. 51REFERENCES. 52List of Appendices . 58Appendix 1: Lag Selection Criteria . 58Appendix 2: Cointegration Results . 59Appendix 3: Responsiveness- Ordinary Least Squares . 60vii

LIST OF FIGURESFigure 2.1: Transmission Mechanism between inflation and Economic Growth . 20Figure 3.1: Annual GDP Growth rate . 25Figure 3.2: GDP for Malaysia . 25Figure 3.3: Inflation Trends from 19990-2012. 26Figure 4.1: Stationarity Autoregression Model . 33Figure 4.2: Economic Growth Trend 1970-2014 . 35Figure 4.3: Experienced Inflation levels 1970-2014. 36Figure 4.4: Malaysia‟s Level of Imports 1970-2014 . 37Figure 4.5: Level of Gross Savings 1970-2014 . 37Figure 5.1: Variance Decomposition . 45Figure 5.2: Impulse Response Functions . 46viii

LIST OF TABLESTable 3.1: Inflation Forecasts for 2016-2020 . 28Table 4.1: Data Sources and Expected results . 38Table 5.1: ADF test Stationarity results. . 40Table 5.2: PP test Stationarity results . 41Table 5.3: Johansen Co-integration test . 42Table 5.4: Model data Summarry results . 43Table 5.5: Responsiveness of GDP to the variables . 44Table 5.6: Granger causality test results . 46ix

LIST OF ABBREVIATIONSCPI: Consumer Price IndexFRBL: Federal Reserve Bank of St LouisGDP: Gross Domestic ProductGS: Gross SavingsINFL: InflationIMP: ImportsADF: Augmented Dickey FullerPP: Phillips Perronx

CHAPTER ONEINTRODUCTION1.1 Background of StudyMacroeconomic policy makers aim to achieve high economic growth and very lowinflation in their economies. Past studies have mainly focused on the effect inflationhas on the economic growth and income distribution with respect tomacroeconomics, this is due to the level of impact inflation has on the economy as awhole. Inflation has thus been a bone of contention with regards to being beneficialor harmful to economic growth.Exorbitant inflation rates tend to inflict various challenges to the economy. Monetaryauthorities are therefore entrusted with a mandate to eradicate inflationaryrepercussions on the economy. Prevailing economic conditions provide a mirror ofpossible inflationary consequences on economy performance. Substantial inflation issynonymous to severe price volatility and this extends to hamper other economicoutcomes such as investment and economic growth.The effects of inflation can be distractive in most cases and they can hamper notablesector of the economy. For instance, inflation distorts the natural tendency of balancethat exists between lending and borrowing. Thus a significant amount of resourcesmight suffer from a decline in monetary in value as it wiped away by monetarypressure. As the effects of inflation become predominant, the erosion of economicvalue will also be taking effect (Bruno and Esaterly, 1996). Thus during the aftermathof exorbitant inflation, individuals with fixed income or assets with fixed interestrates will experience significant decline in value (Dornbuusch, 1977). Inflation hasthus been greatly criticized for further redistributing income. In addition, economicsavings will move in a bilateral position with the level of inflation. Rationalitytherefore forces individuals to utilize their savings before their value is wiped away.On the other hand, it is apparent that increases in inflation is bilaterally related withunemployment. In this regard, efforts to promote employment are said to beinflationary especially when they involve an injection of money supply into the1

economy. This implies that the growth in money supply must be matched or outpacedwith increases in output. However, insights can be obtained that there is a thresholdinflationary level at which increases inflation have positive effects on economicgrowth. Such ideas are of the support that there is a certain level of inflation that isnecessary for economic growth. Threshold inflationary rates are however differentfrom one economy to another or from nation to another. Ideas behind suchdifferences is centered on the level of economic development or economic activitythat is being enjoyed in that country. This implies that a certain increase in price levelstimulate economic activity.Despite this assertion that there is a threshold inflation rate that is stimulative toeconomic growth, major or significant contentions do reveal that inflation posesadverse effects on economic performance and other major outcomes. This wasreinforced by insights provided by Boyd et al. (2001) established that inflation needsto be capped below sustainability. This entails that inflation can pose no harm when itis considered sustainable and opposite effects can set it when deemed unsustainable.Meanwhile Bruno and Easterly (1996) reinforced the same arguments citing thatincreases in price level can inflict severe economic damages especially when theprice increases are unsustainable. Irrespective of such notions, revelations by Boyd etal. (2001) also revealed that stabilization policies must be utilized to bring inflationinto controllable subjection. The nature of stabilization however differs with themagnitude and impact of inflation that is being experienced in that country. Severecases of inflation are usually advocated that they be addressed using tight orrestrictive monetary approaches. Stabilization efforts are therefore stronglyrecommended to adopt a complementary approach which involves a combination offiscal and monetary policy instruments (Dornbusch, 1997).Assertions are very high that effects of inflationary pressure usually set in during thecourse of a wage. A wage is events or circumstance that transpires when a lag existsbetween changes in input, output prices and wages. Notable effects of a wage lag canbe attributed to incidents when such lags remain in force to enable firms to attainhigh levels of profitability. Wage lag thus provide opportunities for furtherinvestment as profits earned provide an incentive to maximize more profits.2

According to Khan and Schımmelpfennıng (2006), the authors developed a model forinflation in Pakistan in order to gather data from 1998 to 2005. The main focus of thestudy was to identify the monetary determinants of inflation in Pakistan. The privatesector credit and CPI was analyzed and the findings of the research showed that in thelong run there exists no tradeoff between growth and inflation however that was notthe case for the short run. Findings further revealed that 5 percent of inflationcontributed to economic stability and growth in the country.1.2 Statement of the ProblemGeneral contention is that inflation has adverse effects on economic implying thatincreases inflation will result in a decline in economic growth. This can beaugmented by ideas established by Dornbusch (1997) which strongly advocates thatinflation be contained at all cost and must not be allowed to fluctuate beyond thesingle digit level. This mirrors inflationary trends that have been taking shape inMalaysia in which inflation increased from the 2.6% mark to 3.9% between theperiods 1991-1996. During the same period economic growth expanded from 4.2% 9% reinforcing the contention that a certain low level of inflation is necessary foreconomic growth. Malaysia happens to be one of the few that had high inflationduring the period of 1973 to 1981 and a low inflation recorded during the period of1985 to 1987. Benefits derived from the low level of inflation were improved growthrates and the low inflation rate was as a result of policy mix incorporated by theMalaysian government in an effort to reinforce economic growth. Contrarydeductions can be made when Malaysia‟s economic performance took and downwardswing to plunge to -7.4% in 1998 and the inflation was revolving around the 1.7%mark (Cheng and Tang, 2000). This has however be the norm during the past 6 yearsand thus contradicts with the same notion that there is a threshold of inflation that hasunilateral relationship between economic growth and inflation. Furthermore, it can benoted that economic growth in Malaysia has fluctuated significantly showingdifferent patterns that contradict with both assertions about the linkage that existbetween inflation and economic growth. This entails that economic growth has beenexhibiting different responses to changes in inflation. This therefore sought toestablish the impact of inflation on economic growth with regards to Malaysia.3

1.3 Research ObjectivesIn this study, critical attention is devoted towards analyzing the impact of inflation oneconomic growth. Proceeding objectives will thrive to attain the following; To determine the responsiveness of economic growth to changes in inflation. To ascertain the existence of a long run relationship between economicgrowth and inflation in Malaysia. To explore policy initiatives that can be put in place to promote economicgrowth without igniting an inflationary response.1.4 Research QuestionsIn order to accomplish the research objectives stated above, this study attempts toanswer the following research questions: What the impact of inflation on economic growth in Malaysia? What is the responsiveness of economic growth to changes in inflation inMalaysia? Is there a long run relationship between economic growth and inflation inMalaysia? What are the policy initiatives that can be put in place to promote economicgrowth without igniting an inflationary response?1.5 HypothesisThe following hypothesis will be tested; H0: Inflation rate has no significant impact on economic growth of Malaysia. H1: Inflation rate has a significant impact on economic growth of Malaysia.1.6 Significance of the StudySignificant importance can be attached to this study in ascertaining the impact ofinflation on economic growth in Malaysia. This is in regards to elucidating theresponsiveness of economic growth to changes in inflation. As such will positionmonetary authorities and scholars in a better position to understand the interlinkages4

that exist between threshold inflation levels and economic growth. It is in this regardthat appropriate economic measures can be undertaken to rectify and alleviate theadverse effects of inflation.1.7 Scope and Limitation of the StudyThe undertaking of this study is mainly centered on analyzing the impacts that areposed by inflation on economic growth. This will be aided by the utilization ofsecondary data which runs from 1970 to 2014. As such will endeavor to establish theresponsiveness of Malaysia‟s economic growth to changes in inflation.1.8 Justification of the StudyThis study in partial fulfill of the requirements of the MSC of Economics at Near EastUniversity. This thesis will be of great value to the following stakeholders to theresearcher as it will enhance the researcher‟s problem solving and analytical skills.Thus through this study, the researcher will be in good position to deduce appropriatesolutions from any inflation and economic growth related matters. Other students atNear East University will be able to access this study for their future studies. Thusthis study will serve as a source of reference about economic growth related issues. Itmust be noted that the ability of this study to solve the problem at hand and going anextra mile to identify deeper and hidden solution, and deduce appropriaterecommendations will improve policy initiatives aimed at improving Malaysia‟seconomic performance.1.9 Organization of the StudyThe study will assume a six chapter structure. Chapter one is an outline of theproblem and its setting. Literature review is addressed in chapter two while chapterthree gives an overview of the Malaysian economic environment, inflation trends andeconomic growth outlooks. Research methodology is dealt with in chapter fourwhereas chapter five looks at the analysis and presentation of results commendations and suggestions for future studies.5atconclusions,policy

CHAPTER TWOTHEORETICAL AND EMPIRICAL LITERATURE REVIEW2.1 Theoretical Literature Review2.1.1 Classical Growth TheoryThe Classical Growth Theory forms a base upon which a significant number ofeconomic growth models are based. The formulator of the Classical Growth TheoryAdam Smith asserts that economic growth can be expressed in the form of a supplyside model. Under this model, the supply side model is assumed to be determined bycapital, labor and technology and expressed in the form of a production function andit assumes the following nature;Y f (K, L, T)Where K is capital, L is labor and T is technology. Thus total output produced isdetermined by capital, labor and technology. This model further asserts that output(Y) is primarily influenced by investment (Ik), changes in productivity (α), landgrowth (Lt) and population growth (PL). As a result,Y f (Ik, Lt, PL, α)This theory implies that growth can exhibit increasing returns to scale because it isself-reinforcing. It also contends that investment ascertained by amount of savings inthe economy and that investment ultimately affect growth levels or patterns (Haslag1995). The theory further posits that the rate at which the economy grows is drivenby income distribution. In addition, it reveals that it is competition for workers amongcapitalists that causes a decline in profits through increases in wages and notdecreasing marginal rate of productivity. This theory does not clearly give a detaileddescription of the nature of association between economic growth and inflation but6

outlines that inflation is as a result of increase in taxes and high wage and salarieswhich hamper profit levels. It therefore contends that the nature of associationbetween economic growth and inflation is bilateral.2.1.2 Neo- ClassicalThe Neo-classical theory is based on the idea by Mundell (1963) which outlines thatthere is a linkage between economic growth and inflation. Mundell asserts thatchanges in inflation or inflationary expectations have an effect on wealth. An increasein inflation is thus said to reduce wealth through a decrease in the rate of return.Mundell posit that the need to acquire more assets causes people to save and in theprocess the prices of assets rise as their demand increases causing interest rates tofall. However, the higher the savings available the higher the level of capitalaccumulation and thus a high level of growth.Tobin (1965) made improvements to the Neo-classical theory to come up with whatis known as the „Tobin Effect‟. This model outlines that consumers postpone currentconsumption by either investing in capital or holding money. Thus individuals areassumed to hold money for either speculative or precautionary motives.The model suggests that as people switch from money they switch to capital whichcauses an increase in capital stock which causes the steady state to increase as well.The increase in output is temporary as the economy is assumed to be in a period ofadjustment or going through a transition. The changes caused by inflation on capitalaccumulation and economic growth are termed the „lazy dog effect‟ were it causeswere both capital accumulation and economic growth will rise but will fall when therate of return on capital starts to decline. Inflation is thus said to be having an upwardeffect on economic growth through capital accumulationHowever, recent models have exhibited that a bilateral association between inflationand economic growth can also exist. For instance, Stockman (1991) argued thatinflation causes the steady state to decline. This is based on the notion that inflationerodes the purchasing power of both capital and consumer goods so individuals willcut down their purchases and as a result the level of the steady stat

responsiveness o inflation to economic growth. The study established that there is a long relationship between economic growth and inflation. The results of the study also showed that Economic growth in Malaysia has an inelastic response to inflationary pressure. Key Words: Inflation, Economic growth, Gross savings, Imports, Malaysia.

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