Money demand, purchasing power parity and inflation modeling in Malaysia

Abstract

Economists have not relented and will not relent for sometime to come in their debate on the causes of inflation. Some characteristic features of earlier inflation models, which can be regarded as their Achilles' heel and a reason for their dismal performance in tracking down inflation in many countries are the loop-sidedness of the models and the lack of empirical investigation into certain claims before using them as foundation of those models. For example earlier models of inflation in Malaysia and in many other countries used growth in money supply to represent excess money supply over money demand without empirically testing the claim that the demand for money is stable or constant. This empirical investigation is necessary because, an increase in money supply, which is followed, by a corresponding increase (in the same amount) in money demand may not cause inflation. The complexity and dynamics of inflation transcends explanation by one theory. The paper was able to establish cointegration among the variables in the external sector and the monetary sector via the Johansen approach. By combining the two dominant theories (money demand and purchasing power parity) of price formation in an open economy, the paper came to the conclusion that inflation in Malaysia is influenced by growth in money supply although no evidence was found to support the theoretical axiom that inflation is driven by excess money supply over money demand. The purchasing power parity theory was also significant in explaining inflation in Malaysia. The within and out of sample performance of the error correction model of inflation developed by the paper and the ARIMA model used by the paper stamped out the error correction model of inflation as been better than the ARIMA model in explaining inflation in Malaysia