The study of exchange rates behavior in Malaysia by using NATREX model

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THE STUDY OF EXCHANGE RATES BEHAVIOR IN MALAYSIA BY USING
J. M. Shukri
1,2,*
1F
aculty of Business Management, Universiti Technologi MARA, 23000 Dungun,
2Faculty of Economics
and Management,
Published online:
ABSTRACT
This paper aims to estimate equilibrium exchange rates and identify the determinants of
macroeconomics fundamentals affecting exchange rates in Malaysia. By using Natural Real
Exchange Rates (NATREX) model, this study adopts the Autoregressive Distributed
(ARDL) model to examine the long run relationships (or cointegration) among variables and
the dynamic effect within variables in the short run for the period 1970 to 2012.
suggest that the terms of trade, dependency ratio of the young, and
play an important role in influencing the exchange rates movement in
also reveals that the misalignment of exchange rates is quite small and stable in Malaysia
during 1983 to 2012, except in 1995
Keywords: na
tural real exchange rates; exchange rates misalignment; bound testing
Author Correspondence, e-
mail:
doi:
http://dx.doi.org/10.4314/jfas.v9i3s.55
Journal of Fundamental and Applied Sciences
ISSN 1112-9867
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http://www.jfas.info
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THE STUDY OF EXCHANGE RATES BEHAVIOR IN MALAYSIA BY USING
NATREX MODEL
1,2,*
, M. S. Habibullah2, Z. Yusop2
and L. Chin
aculty of Business Management, Universiti Technologi MARA, 23000 Dungun,
Terengganu, Malaysia
and Management,
Universiti Putra Malaysia
, 43400 Serdang, Selangor,
Malaysia
Published online:
10 September 2017
This paper aims to estimate equilibrium exchange rates and identify the determinants of
macroeconomics fundamentals affecting exchange rates in Malaysia. By using Natural Real
Exchange Rates (NATREX) model, this study adopts the Autoregressive Distributed
(ARDL) model to examine the long run relationships (or cointegration) among variables and
the dynamic effect within variables in the short run for the period 1970 to 2012.
suggest that the terms of trade, dependency ratio of the young, and foreign direct investment
play an important role in influencing the exchange rates movement in
Malaysia.
also reveals that the misalignment of exchange rates is quite small and stable in Malaysia
during 1983 to 2012, except in 1995
.
tural real exchange rates; exchange rates misalignment; bound testing
mail:
mohdshukri@tganu.uitm.edu.my
http://dx.doi.org/10.4314/jfas.v9i3s.55
Journal of Fundamental and Applied Sciences
http://www.jfas.info
Creative Commons Attribution
-NonCommercial 4.0
Research Associations
category.
THE STUDY OF EXCHANGE RATES BEHAVIOR IN MALAYSIA BY USING
and L. Chin
2
aculty of Business Management, Universiti Technologi MARA, 23000 Dungun,
, 43400 Serdang, Selangor,
This paper aims to estimate equilibrium exchange rates and identify the determinants of
macroeconomics fundamentals affecting exchange rates in Malaysia. By using Natural Real
Exchange Rates (NATREX) model, this study adopts the Autoregressive Distributed
Lag
(ARDL) model to examine the long run relationships (or cointegration) among variables and
the dynamic effect within variables in the short run for the period 1970 to 2012.
The results
foreign direct investment
Malaysia.
The result
also reveals that the misalignment of exchange rates is quite small and stable in Malaysia
tural real exchange rates; exchange rates misalignment; bound testing
; ARDL.
Research Article
Special Issue

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 698
1. INTRODUCTION
Malaysia is experiencing rapid economic growth especially during the late 20th century
through trade liberalization. The rate of economic growth in Malaysia is growing at the
average of 6.5% annually from 1957 to 2005. In 2012, the gross domestic product (GDP PPP)
was recorded at USD671.8 billion and the rate of economic growth was 5.6%.The
international trade plays an important role in the Malaysian economy and manufacturing
sector has contributed for over 40% of the GDP. Furthermore, the establishment of the
Association of Southeast Asian Nations (henceforth ASEAN) since 1967 enhanced
international trade among ASEAN members as well as the trade to the rest of the world,
thereby involving high transaction of the foreign currency. Malaysia is also experiencing the
same impact as this country is a member of ASEAN. Fig. clearly indicates that the trend of
exports and imports of goods and services in Malaysia has increased tremendously from 1980
until 2011.
However, this phenomenon (the enhancement of international trade) does not really indicate a
good economic performance as a whole for Malaysia. According to [3], a high volatility of
exchange rates by small open economy country such as Malaysia especially that rely on
international trade may cause national currency to be easily coaxed into undervaluation or
overvaluation trap. Generally, the appreciations of domestic currency imply the increasing in
competitiveness of the national currency in the currency markets. However, it does not imply
increases in competitiveness if high appreciation causes the domestic currency to be
overvalued.
Besides that, the internal financial systems in Malaysia are still weak and less resilient, which
had only worsened the situation. Thus, with a small open economy and newly industrialized
market economies, the Malaysian currency is readily confronted with volatility and
misalignment against foreign currencies such as the US dollar. The exchange rate
misalignment will occur when there are deviations from its equilibrium path, thus creating
opportunities for arbitrage activities.

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 699
Fig.1. Export and import of goods and services in Malaysia, 1980-2011 (in average)(Source:
United Nation Statistic Department (UNSD))
Another issue of concern is the Asian financial crisis 1997 that started in Thailand, which had
affected and inhibited the economic growth and development in Malaysia. The crisis also has
led to a currency crisis in Malaysia forcing her policy makers back then, to switch the
exchange rate regime to fixed exchange rates. However, in [1-2] show that there is little
evidence of exchange rate misalignment found in Malaysia including Indonesia, Philippines,
Singapore and Thailand during the crisis. Meanwhile, in [13] suggest that exchange rate
misalignment and volatility are important determinants in encouraging Malaysia’s import
flows especially during the 1997 Asian financial crisis. Why some countries should take
concern to the exchange rates misalignment? How to assess the equilibrium exchange rate
thereby its misalignment?
Firstly, according to [4], the effects of misalignment of currency to a country’s economy are
quite huge. For instance, the overvaluation of the currency is believed to have caused the
national currency to experience depreciation and therefore reduced its economic growth. On
the other spectrum, the undervaluation of the currency implies that the national currency tend
to appreciate thus making the currency expensive against foreign currency. This usually
increase imports and decrease exports demand, thus creating deficit in trade balance. However,
in [15] provides evidence that undervaluation of the currency (a high real exchange rate)
stimulates economic growth. Meanwhile, according to [19], the persistent exchange rate
misalignments are able to generate severe macroeconomic disequilibrium often leading to
costly external imbalances and sometimes can be considered as an indicator of potential crisis.
Secondly, the traditional theory to study the misalignment of exchange rates was introduced
0
50
100
150
200
250
300
1980-1989 1990-1999 2000-2009 2010 2011
US$ Billions
Export
Import

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 700
by Gustaz Cassel in 1918 through the Purchasing Power Parity (PPP) and the Law of One
Price (LOP) theories. The PPP/LOP models used the price based estimates and are relatively
easy to implement. However, previous studies argued that these theories are not perfect as it
only provides the behavior of exchange rate in the long-run and fail to predict well especially
in the short-run. Furthermore, the PPP/LOP theories does not address the economically
interesting question of whether a particular exchange rate is driven by economics fundamental.
In other word, this concept does not address all factors which may account for deviations
from PPP levels in terms of a time-varying equilibrium path of the exchange rate. Fig.
describes the theory of PPP and LOP, and the misalignment of exchange rate in Malaysia.
In the case of Malaysia, the study on exchange misalignments is still lacking. For instance, the
study conducted by [1-2] explain the exchange rates behavior using the monetary model. Both
of these studies estimate exchange rates movement using relative foreign and domestic
monetary aggregate, income differential, interest rate differential and expected inflation
differential as regressors. However, the models in these studies exclude other macroeconomic
fundamental factors which are also important determinants of the exchange rate.
70
80
90
100
110
120
130
140
150
1970 197 5 1980 198 5 1990 199 5 2000 200 5
2010
ER RE L_P RICE
I
NDEX
Fig.2. Purchasing power parity, Malaysia/United States, 1970-2012 (Source: World
Development Indicator (WDI), United Nation Statistical Division (2012) and authors’
computations. Note: Index 1970 = 100)
Besides that, the study conducted by [13] using NATREX model highlights that the real
economic fundamentals are government consumption, real interest rate, terms of trade and
productivity index. However, according to [20], the social time preference such as the
dependency ratio of the young (DEPY) should also be included in the model. Other important
fundamental factors that should be considered are the tax revenue and foreign direct

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 701
investment. Fig. clearly indicates that there are downward trends (correlation) in all
macroeconomics fundamental variables except real interest rate.
Therefore, the purpose of this paper is to estimate the equilibrium exchange rates using
NATREX model and identify the macroeconomic fundamentals as determinants of the
exchange rate for Malaysia. Based on our best knowledge, this is the first time that the
dependency ratio of the young, tax revenue and foreign direct investment were included as the
macroeconomics fundamental factors in examining equilibrium exchange rates for a country.
This paper adopted the autoregressive distributed lag (ARDL) model approach to examine
long run relationships (or cointegration) among variables and the dynamic effect within
variables in the short run.
0
40
80
120
160
200
0 20 40 60 80 100 120 1 40
160
TOT
REER
80
100
120
140
160
180
200
0.80 0.85 0. 90 0.95 1. 00 1.05
1.10
TFP
REER
80
100
120
140
160
180
200
9,000 10,000 11, 000 12,000
13,000
DEPY
REER
80
100
120
140
160
180
200
10 20 30 40 50 60 70 80 9 0
100
R
REER

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 702
80
100
120
140
160
180
200
.0000008 . 0000016 .0 000024
T
REER
80
100
120
140
160
180
200
0 2,000 4,000 6,000 8, 000 10,000
14,000
FDI
REER
Fig.3. The relationship between exchange rates and macroeconomics fundamental in
Malaysia, 1970-2012(Sources: World Development Indicators (WDI), United Nations
Conference on Trade and Development (UNCTAD), United Nation Statistic Department
(UNSD), Penn World Table, Asian Development Bank (ADB), International Financial
Statistic (IFS). Note: REER-real effective exchange rate; TOT-terms of trade; TFP-total factor
productivity; DEPY-dependency ratio of the young; R-real interest rate; T-tax revenue and
FDI-foreign direct investment.)
This paper is organized as follows. The overview of the determination of equilibrium
exchange rate in Malaysia is discussed in section 1. While, section 2 is a brief discussions of
the theoretical framework of equilibrium exchange rates, the research design and
methodology to estimate the equilibrium exchange rates in Malaysia by applying the
NATREX model. The results estimations and research findings are discussed in section 3.
Section 4 is the discussion of the misalignment of currency in Malaysia and finally, section 5
will summarize the main findings and conclude with some policy implications.
2. METHODOLOGY
2.1. Model (Theoretical Framework)
The natural real exchange rates (NATREX) model developed by [17] to understand deeper the
misalignment of exchange rates and its macroeconomic fundamental. NATREX model is
employed in this study due to several reasons. Firstly, the NATREX model allows

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 703
macroeconomics fundamental factors to describe the misalignment of exchange rates [13].
Secondly, this model allows exchange rates to vary over time responding to the changes in the
fundamentals [5, 18]. Lastly, this model does not require the observed real effective exchange
rates (REER) and the real equilibrium exchange rate to be stationary [5-6, 13]. Generally, the
NATREX model is an estimation of macro-econometric model by using time series analysis,
imposing external and internal balance and solving for the equilibrium real exchange rate in
the medium-term medium-run to long-run (for a comprehensive discussion see [5, 17, 20].
The model used is shown in the following Equation (1):
LER= α+ αLTOT+ αLTFP
+ αLDEPY+ αLR+ αLT+ αLFDI+ ε (1)
whereLERt, α and ε denotes as real effective exchange rate, vectors of coefficients and error
term respectively. Any deviation from equilibrium is reflected in the error (εt) term, which
includes both short-term influences and random disturbances; LTOT and LTFP are terms of
trade and total factor productivity respectively; LDEPY denote dependency ratio of the young
population; LR, LT and LFDI are real interest rates, tax revenue and foreign direct investment
respectively. All variables are in natural logarithm. We expect a priori the expected sign of the
variables as α≷ 0, α, α> 0 and α, α, α< 0.
According to [7, 13], the effects of terms of trade on exchange rate seems to be ambiguous
depending on the relative importance of the substitution-income effects. An improvement in
the terms of trade leads to the reduction in the cost of imported inputs in the production
process, generating exchange rate depreciation through the substitution effect and hence α
is expected to be positive, vice versa. Meanwhile, according to [20], the total factor
productivity is able to influence domestic output (Y) where the higher figure in the total factor
productivity is due to technology growth and efficiency, and thereby increased the domestic
output. The increase in total factor productivity and domestic output leads to appreciation of
the real exchange rates in the long run. Further, in [20] proposed that the coefficient of the
dependency ratio of the young in the model shows that the higher figure in the relative
number of young (under 15) increases the consumption-to-income ratio. The increase in
consumption leads to increase in borrowing from foreign country, hence causes depreciation
(reduce) of the real exchange rates in the long run. Another study conducted by [16] predicted

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 704
that the higher values in real interest rates leads to an increase in interest payment of
net-debtor countries. Hence, the increase in real interest rates causes depreciation of currency.
Following [11, 20], the tax revenue is one of the tools in explaining cost of capital function.
Higher taxes would not stimulate business sector investment by increasing the user cost of
capital. Hence, the aggregate investment will fall causing a depreciation of the real exchange
rates in the long run. Meanwhile, another study conducted by [12] suggest that the growth in
debts in the long run would cause the current account deficit resulting from the factor
payments on the productive foreign direct investment which will make the currency
depreciate.
The ARDL approach proposed by [14] is used to estimate the equilibrium exchange rate
model. The advantage of using ARDL approach is that it is applicable regardless of the
stationarity properties or irrespective of whether the regressors are purely I(0) or I(1), or
mutually cointegrated. This is a useful approach that bypasses the need for pre-testing the
integration order of variables, which the potential bias associated in the unit root test can be
avoided. Indeed, the ARDL approach is robust for cointegration analyses with small sample
study [14].
A specified ‘restricted error correction model’ (RECM) of the ARDL model can be used to
determine the long-run relationships. For the NATREX model we can be employ RECM to
examine whether LTOTt,LTFPt, LDEPYt, LRt, LTt and LFDIt are long-run forcing variables
for REERt. Therefore, Equation (1) can be rewritten as the following equation.
ΔLER=
γ+∑γΔLER

 +∑γΔLTOT

 +∑γΔLTFP


 +∑γΔLDEPY

 +
∑γΔLR

 +∑γΔLT

 +∑γΔLFDI

 + βLER + βLTOT +
βLTFP
 + βLDEPY + βLR + βLT + β
LFDI + v (2)
wherev is disturbance term. By using the F-test, the null hypothesis of non-existence of the
long-run relationship for NATREX model is tested onH: β= β= β= β= β= β=
β= 0against H: β≠ β≠ β≠ β≠ β≠ β≠ β≠ 0. According to [14], the bounds
F-test must be valid by ensuring that there is no serial correlation. In this study, we employ the
LM statistics for testing the hypothesis of no serial correlation. Meanwhile, the

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 705
Schwartz-Bayesian information criterion (SBC) is used to determine the optimal lag length, k
and n above.
From Equation (2), the long run equation presented as in Equation (1) can be derived when
we have α=
∑
, α=∑
∑
, α=∑
∑
, α=∑
∑
, α=∑
∑
, α=∑
∑
and α=∑
∑
.In order to estimate the short-run coefficients and to estimate the speed of
adjustment, the following ARDL-Restricted ECM (RECM) equation can be specified by
rewriting Equation (2) as the following equation:
ΔLER=
δ+∑δΔLER

 +∑δΔLTOT

 +∑δΔLTFP


 +∑δLDEPY

 +
∑δΔLR

 +∑δΔLT

 +∑δΔLFDI

 + λEC + w (3)
where ECt-1 is the residuals lagged one period from the long-run Equation (1) between the
dependent and independent variables in level. The significance and the negative sign of the
error correction term (ECt-1) indicates co-integration (or long run relationships), and λ
measure the speed of adjustment and the deviation from equilibrium. However, the negative
value for λ suggests that the model is stable and any deviation from equilibrium will be
corrected in the long-run. According to [14], the existence of an error correction model
implies co-integration of the variables. Therefore, the long-run relationship is valid and free
from spurious regression problem.
2.2. Data
This study uses annual data for Malaysia starting from 1970 until 2012. The REER is the
weighted average of a country's currency relative to the trading partners of Malaysia. An
increase in the index indicates appreciation of the home currency against the basket of
currencies of trading partners. The TOT is the ratio of domestic export unit value (export price
in US Dollars) to import value (import price in US Dollars) as a proportion of the equivalent
effective foreign ratio. Meanwhile, TFP and DEPY are total factor productivity constant
national prices (2005 = 100) and dependency ratio of the young as population under 15
deflated by working population respectively. R is the real lending interest rate adjusted for
inflation as measured by the GDP deflator. T is tax revenue divided by nominal GDP. Whilst,
FDI is ratio of foreign direct investment net inflows to GDP.

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 706
All the data series were obtained from various sources such as the International Monetary
Fund’s International Financial Statistics (IMF/IFS), United Nations Statistical Division
(UNSD), United Nations Conference on Trade and Development (UNCTAD), Asian
Development Bank (ADB), Worldbank's World Development Indicators (WDI), Penn World
Table (PWT) and www.bruegel.org.
3. RESULTS AND DISCUSSION
3.1. Results of Unit Root Test
The discussions begin with the analysis of unit root test using
Kwiatkowski-Phillips-Schmidt-Shin (KPSS) approach. The purpose of employing the unit
root tests is to examine the existence of stochastic non-stationary in the series.
Table 1 is the empirical results of the unit root tests. All the variables in this study such as
LER, LTOT, LTFP, LDEPY, LR, LT and LFDI are tested based on “no trend and constant”,
“trend and constant”. Based on Table 1, the outcomes from the unit root tests of KPSS clearly
indicates that all variables are mixture of I(0) and I(1), and none is I(2). Therefore, the ARDL
modeling approach can be used in the estimation of NATREX model.
Table 1. Results of KPSS unit root test
Var.
KPSS Unit Root Tests, T-Statistics
Series in Level Series in 1st Diff.
No Trend Trend No Trend Trend
LER
0.75***(5) 0.120*(4) 0.113(4) 0.100(4)
LTOT
0.107(3) 0.102(3) 0.041**(2) 0.04**(2)
LTFP

0.231(4) 0.112(4) 0.124(2) 0.110(2)
LDEPY
0.664**(5) 0.118(10) 0.290(5) 0.12(10)
LR
0.492**(2) 0.107(1) 0.193(1) 0.171(1)
LT
0.500**(5) 0.116(4) 0.147(3) 0.114(3)
LFDI
0.74***(5) 0.116(4) 0.085(4) 0.052*(4)
Note: The value in parentheses (.) represent the automatic bandwidth selected based on
Newey-West method using Bartlett kernel. The ***, ** and * indicate the statistically

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 707
significant level at 1%, 5% and 10%. LER-real effective exchange rate, LTOT-terms of trade,
LTFP-total factor productivity, LDEPY-dependency ratio of the young, LR-real interest rate,
LT-tax revenue and LFDI-foreign direct investment. All variable are in logarithm.
3.2. Results of Cointegration Test
The next analysis is to determine the existence of a long-term cointegrating relationship
between the exchange rates, and the macroeconomics variables in Malaysia by using the
ARDL bound test. Table 2 presents the empirical result of bound test for NATREX model and
the lag length for this regression were automatically selected based on Schwarz Bayesian
Criterion (SBC).
Table 2. Results of cointegration bounds test
F-Statistics Lower Bound Upper Bound
F-Statistics
[14]
90%
95%
2.141
2.476
3.250
3.646
Computed F-Statistic F = 4.2809**
Note: ** and * indicate the statistically significant level at 5% and 10%. The critical values
are obtained from [14].
The result of bound test shows that the F-statistic for NATREX model fall above the upper
bound critical value at 5% significance level. This result suggest that cointegration exists
among the variables in the model under investigation.
3.3. Diagnostic Tests
The statistical validity of the ARDL model has been ascertained by a battery of tests, which
includes serial correlation LM test, ARCH test for heteroscedasticity and Jarque-Bera
normality test on the residual. Generally, the diagnostic tests for NATREX model in Malaysia
produce good results. Table 3clearly indicates that the model is free from serial correlation
and heteroscedasticity, and the residual is normally distributed.
Table 3. Results of diagnostic tests for ARDL

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 708
Diagnostic Checking P-Value
Serial Correlation
Normality
Heteroscedasticity
0.770
0.873
0.151
Note:ARDL(2,2,0,0,0,1,0) was automatic selected on the basis of SBC.
3.4. Estimates of Long-Run Model
Table 4 shows the long run coefficients of the ARDL model with estimated lag orders for this
model as ARDL(2,2,0,0,0,1,0). The optimal lag lengthwas automatically selected on the basis
of SBC. The results clearly indicates that LTOT,LDEPY and LFDI are statistically significant
at least at the 5% level. In the long run, the model explains that the higher level of terms of
trade, dependency ratio of the young population and foreign direct investment could lead to
depreciation in the exchange rates in Malaysia. Following [13, 20], the negative impact of
terms of trade on exchange rates explain that the improvement in terms of trade reduces
demand for non-tradable, decreases the users cost of capital (consumption effect) and
stimulate investment demand in the non-tradable component (investment effect). Therefore,
the relative price of non-tradable to imports will decrease as well as real exchange rates
(depreciation) due to the consumption effect which are greater than investment effect.
Meanwhile, the negative impact of dependency ratio of the young on exchange rates explains
that the higher in the relative number of young (under 15) increased the
consumption-to-income ratio. The increasing consumption leads to increase in borrowing
from foreign country, hence causing depreciation (reduce) of the real exchange rates in the
long run. Besides that, the negative impact of foreign direct investment on exchange rates in
Malaysia in the model is not compatible with the explanation of theoretical predictions.
Nevertheless, this result is consistent with a study conducted by [9]. The result in their study
showed that the foreign direct investment has the opposite sign than was expected for
Slovakia. The possible explanation of this result is due to high volatility of foreign direct
investmentduring the Russian and Asian financial crises 1997/1998 that creates uncertainty
among foreign investors thus influencing the stability in exchange rates, hence the exchange

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 709
rates tend to be depreciated.
Table 4. Results of long-run coefficient
Variables Exp. Sign Coeff. S.E. T-Stat
LTOT
LTFP
LDEPY
LR
LT
LFDI
C
+/-
+
-
-
-
+
-0.913
-0.257
-1.735
-0.073
-0.095
-0.047
24.662
0.233
0.418
0.275
0.111
0.075
0.021
3.757
-3.922***
-0.615
-6.318***
-0.657
-1.257
-2.279**
6.564***
Notes: Asterisk ***, ** and * denotes statistically significance at 1%, 5% and 10%,
respectively. LTOT-terms of trade, LTFP-total factor productivity, LDEPY-dependency ratio
of the young, LR-real interest rate, LT-tax revenue and LFDI-foreign direct investment. All
variable are in logarithm.
3.5. Estimates of Error Correction Model (ECM)
According to [8], the error correction model (ECM) is the short-run model with long-run
information. If the ECM is negative and significant, therefore these imply that independent
variable Granger cause dependent variable and are cointegrated. Based on Table 5, the error
correction term in the model shows that it is significant at 1% level. It also carries the
expected negative sign. This indicates that the model is stable and any deviation from
equilibrium will be corrected in the long run [10]. The coefficient of the error correction term
implies the speed of adjustment. Based on the result, the coefficient of the error correction
term for NATREX model is 0.50. This indicates that 50 % of the previous year’s shocks adjust
back to long-term equilibrium in the current year. This result also provides further evidence of
the existence of a stable long-run relationships among the variables in the exchange rates
model.
Table 5. Results of short-run coefficient and error correction model (ECM)

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 710
Variables Coeff. S.E. T-Stat
∆LER(−1)
∆LTOT
∆LTOT(−1)
∆LTFP
∆LDEPY
∆LR
∆LT
∆LFDI
∆C
ECM(−1)
0.357
-0.225
0.262
-0.129
-0.871
-0.037
-0.222
-0.024
12.379
-0.502
0.137
0.081
0.090
0.232
0.270
0.056
0.048
0.011
3.240
0.140
2.616**
-2.786***
2.920***
-0.557
-3.230***
-0.654
-4.595***
-2.138**
3.821***
-3.586***
Notes: Asterisk ***, ** and * denotes statistically significance at 1%, 5% and 10%
respectively. LER-real effective exchange rate, LTOT-terms of trade, LTFP -total factor
productivity, LDEPY-dependency ratio of the young, LR-real interest rate, LT-tax revenue
and LFDI-foreign direct investment. All variable are in logarithm.
Another characteristic of the ARDL model is that the dependent variables not only can be
explained by the independent variables in the model, but it can also be explained by the value
of itself in the past. Based on Table 5, the result for short-run relationship in the model shows
that the lagged one period of the exchange rates is positive and statistically significant at 1%
level. This explains that a 1% increase (appreciation) in past one year exchange rates lead to
appreciation in exchange rate at 0.36 % in the current year.
3.6. Misalignment of Exchange Rates in Malaysia
This section is going to present the misalignment of Ringgit against US dollar. Generally, the
misalignment of exchange rates is the deviation of the actual exchange rate from an estimate
of its equilibrium values [9]. Table 6 shows the percentage of the misalignment in exchange
rate, and Fig. shows the plot of residuals and two standard error bands. The result reveals that
the misalignment of exchange rates is quite small and stable in Malaysia during 1983 to 2012.
In addition, the result shows that Malaysia had experienced a shock or spike of exchange rates
in 1995 due to an excessive foreign exchange speculation. However, the Malaysian

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 711
government has intervened to offset the significant upward pressure on the currency.
Table 6. Misalignment of exchange rates in Malaysia, 1983-2012
Year % Year %
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
0.01
0.03
0.05
-0.05
-0.01
-0.03
0.04
-0.02
-0.04
-0.00
-0.04
-0.02
0.84
0.05
0.02
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
-0.05
0.05
0.02
0.08
0.02
-0.06
-0.03
0.01
0.00
-0.01
0.01
-0.04
0.01
0.01
-0.02
Notes: Figures are exchange rate misalignments in percentage (%). A misalignment is the
residual between actual and fitted values of exchange rate. Positive (negative) value for
residual denotes an undervaluation (overvaluation).
Fig.4. Residuals and two standard error bands for NATREX model(Notes: The movements of
the residuals above zero (positive value) are associated with undervalued exchange rate,
whilst below zero (negative value) are associated with overvalued exchange rate.)
On the other hand, our results further suggest that the NATREX model fit the data very
Plot of Residuals and Two Standard
Error Bands
Years
-0.02
-0.04
-0.06
-0.08
0.00
0.02
0.04
0.06
0.08
0.10
1972 1977 1982 1987 1992 1997 2002 2007 2012
2012

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 712
closely throughout the period. Fig. shows that the model tracked the actual exchange rate well
and managed to get a considerable number of turning points. This results is similar to the
study conducted by [1-2].
Fig.5. Actual values and fitted values of NATREX model in Malaysia(Note: Malaysia
(Malaysian Ringgit, MYR, RM))
4. CONCLUSION
This study has investigated the exchange rates behavior by estimating equilibrium exchange
rates in Malaysia. In order to understand deeper the misalignment of exchange rates and its
macroeconomic fundamental in Malaysia, the NATREX model is used. By adopting the
ARDL modeling approach, this study is able to make correct analyses of the short-run and
long-run relationships (cointegration) between exchange rates and its macroeconomic
fundamental. Hence, we find that the terms of trade, dependency ratio of the young and
foreign direct investment are important factors influencing exchange rates in Malaysia.
The investigation of the misalignment of exchange rates was done by examining the
difference (residuals) between the actual real exchange rates and the estimated exchange rate
calculated from the NATREX model. The result shows that the misalignment of exchange
rates for Ringgit Malaysia is quite small. The overvaluation of Ringgit Malaysia in NATREX
model lies in the range of 0.01-0.06 %, whilst the undervaluation lies in the range of
0.01-0.84 %. Generally, the misalignment of exchange rates is stable in Malaysia during 1983
to 2012 except in 1995 (see Table 6 and Fig.).
This paper also showed that the macroeconomics fundamental factors using NATREX model
are also important variables in determining exchange rates behaviors, instead of price based
factors using PPP/LOP models (see Fig. and Fig.).
The policy implications of this study are suggested as follow. Firstly, the long-run and
Plot of Actual and Fitted Values
LREER
Fitted
Years
4.0
4.5
5.0
5.5
1972 1977 1982 1987 1992 1997 2002 2007 2012
2012

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 713
short-run relationship between exchange rates and its macroeconomic variables (terms of
trade, dependency ratio of the young, and foreign direct investment) in NATREX model
shows that these variables are important determinants of the exchange rates. This evidence
suggests that the exchange rates in Malaysia are driven by its macroeconomic variables.
Secondly, the policy makers should take into account the macroeconomic indicators in order
to achieve economic goals for Malaysia. In this paper, the terms of trade, dependency ratio of
the young and foreign direct investment play important roles to achieve the goals. Therefore,
policy makers in Malaysia can monitor whether the real exchange rates would be undervalued
or overvalued in the future by tracking these macroeconomics variables.
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How to cite this article:
Shukri J M, Habibullah M S, Yusop Z, Chin L. The study of exchange rates behavior in

J. M. Shukri et al. J Fundam Appl Sci. 2017, 9(3S), 697-715 715
Malaysia by using natrex model. J. Fundam. Appl. Sci., 2017, 9(3S), 697-715