CENTRE FOR APPLIED MACROECONOMIC ANALYSIS
The Australian National University
CAMA Working Paper Series
THE RELATIVE IMPORTANCE OF MONETARY POLICY
TRANSMISSION CHANNELS IN MALAYSIA
Hsiao Chink Tang
The Australian National University
CAMA Working Paper 23/2006
The Relative Importance of Monetary Policy
Transmission Channels in Malaysia∗
Hsiao Chink TANG†
Centre for Applied Macroeconomic Analysis,
the Australian National University
This paper investigates the relative strength of four monetary policy transmission
channels (exchange rate, asset price, interest rate and credit) in Malaysia using a 12-
variable open economy VAR model. By comparing the baseline impulse response with
the constrained impulse response where a particular channel is being switched off, the
interest rate channel is found to be most important in influencing output and inflation
in the horizon of about two years, and the credit channel beyond that. The asset price
channel is also relevant in the shorter-horizon, more so than the exchange rate channel,
particularly in influencing output. For inflation, the exchange rate channel is more rele-
vant than the asset price channel.
Keywords: Monetary policy transmission mechanism, vector autoregression, small open
Most economists would agree that monetary disturbances have important short-term ef-
fects on economic activities such as consumption and investment (Taylor (1997)). Nonethe-
less, when it comes to the precise nature in which monetary policy actions are transmitted
throughout the economy, there appears to be a genuine lack of consensus.
monetary policy transmission mechanism has been called the “black box” (Bernanke and
∗This paper has benefitted from discussions with and comments and suggestions from Adrian Pagan, War-
wick McKibbin, Heather Anderson, Mardi Dungey, Renee Fry and Mohammed Hasni Shaari and anonymous
referees. Financial assistance from ARC grant number, DP0664024 is acknowledged. The usual disclaimer
†Research School of Pacific and Asian Studies, the Australian National University, Canberra ACT 0200,
Australia. Tel:(2)6125 7653, Fax:(2)6125 3700, email: email@example.com
Gertler (1995)). The aim of this paper is, therefore, to shed some light on the “black box”
of monetary policy transmission mechanism in Malaysia, specifically to uncover the relative
strength of the different channels of monetary transmission. Four transmission channels
are studied: interest rate, credit, exchange rate, and asset price/wealth channels, based on
their particular merits in Malaysia. As Bank Negara Malaysia (BNM), the central bank
of Malaysia has increasingly shifted towards the use of indirect monetary instruments, the
interest rate channel should gain greater prominence. Since the banking sector has been the
traditional source of funding for firms and individuals, the credit channel is also expected
to play an important role.1The exchange rate channel should also be significant especially
given Malaysia is a small and highly open economy with total trade double that of GNP.
The increased popularity of the stock market as an alternative saving/investment avenue,
understandably since the stock market is the most developed segment of the capital market,
makes the asset price channel another interesting conduit to be studied.
For central banks, knowledge about the relative importance of the transmission channels
provides useful policy information and suggestions. First, a more accurate assessment of
the nature of monetary conditions can be gleaned. If the interest rate channel is the main
conduit, then the short-term real interest rate can be a good indicator of the monetary
policy stance (page 473, Walsh (2003)). On the other hand, if the exchange rate channel
is important, even if domestic interest rates are low, a strong Malaysian ringgit can be
associated with tight monetary conditions. Viewed in the context of a highly open economy,
a strong ringgit could be an effective strategy to ward-off inflationary pressures from abroad
and cool an overheating economy.
Similarly, if the credit channel is important, loan activity is also an important signal to
watch. A case in point was Malaysia’s experience in the early part of the 1990s amidst a
period of relatively high interest rates which coincided with high loan growth, particularly
for the purchase of properties and shares. To judge from interest rates alone, monetary
policy would have been inaccurately interpreted as sufficiently contractionary. In reality, the
period was connected with the stock market bull-run, which oozed “irrational exuberance”
and precipitated in a borrowing binge with the view that any potential upside gains would
more than offset the exorbitant cost of borrowing.
Second, the presence of other transmission channels provides practical insights into mon-
etary policy strategies when the main channel becomes benign. Consider a scenario where
nominal interest rates are near zero percent, and the economy is also hit with deflationary
fears (a situation reminisces the US monetary policy experience a few years back). In such
1Strictly speaking, the credit channel can be categorised into the bank lending channel and the balance
sheet channel. For simplicity, the term, credit channel, is used. There has been a growing literature attempting
to distinguish the presence of the bank lending channel versus the balance sheet channel through the use of
bank or firm-level (micro) data. For example, see Oliner and Rudebusch (1995, 1996) and Kashyap and Stein
(2000). The focus of this paper will be on the use of macro data as the lack of micro-level data for Malaysia
precludes detailed analysis separating the bank lending and the balance sheet channels.
circumstance, the interest rate channel becomes impotent should additional easing of the
nominal interest rates be required to avoid further worsening of the economy. The pres-
ence of other transmission channels provides other viable strategies. Chief amongst these is
quantitative monetary easing by pumping liquidity into the system to raise expectations in
general price levels and to halt the deflationary slide. Policymakers can also reflate other
asset prices such as stocks and properties, thereby boosting individual wealth to stimulate
aggregate demand (Mishkin (1996)). Knowing which channel is more relevant provides valu-
able information to policymakers for enhanced monetary policy effectiveness.
The existence of other transmission channels also means monetary policy is more potent
– a small change in interest rates will have a larger impact on the economy than would
otherwise be the case if the central bank were to be solely dependent on the interest rate
channel. Bernanke and Gertler (1995) state the credit channel “can amplify and propagate
conventional interest rate effects” (page 28). If other channels, such as the exchange rate
and asset price channels are also relevant, the potency of monetary policy will be further
enhanced. For instance, the presence of the exchange rate channel in a small open economy
like Malaysia, provides policymakers with a flexible and powerful policy option to boost the
country’s competitiveness should this be deemed necessary. As such, knowing which channel
is relatively important can provide a better indication of the likely impact of monetary policy
shocks on the real economy.
A long list of studies has looked at the monetary policy transmission mechanism using
the vector autoregression (VAR) methodology. Some examples include Sims (1980, 1992);
Bernanke and Blinder (1992); Ramaswamy and Sloek (1997); Christiano et al. (1999) and
Morsink and Bayoumi (2001). Nonetheless, none of these studies focus on the issue of the
relative strength of the transmission channels. The approach adopted in this thesis builds on
this literature and also the shutdown methodology found in Ramey (1993) and Ludvigson et
al. (2002), among others.2The approach involves shutting down or muting one channel at a
time and comparing that with the baseline impulse response when all channels are operating.
In addition, particular attention is also devoted to modelling Malaysia as a small and open
economy. This involves invoking the open economy framework in VAR modelling, whereby
the US is taken as representative of the world economy e.g., Cushman and Zha (1997) and
Dungey and Pagan (2000). Nonetheless, unlike the latter two papers which use a zero-type
or structural identifying restriction, this study uses a recursive identifying restriction. This
appears to be reasonable first step considering the lack of theoretical guidance in estimating
a structural VAR where the interest encompasses several transmission channels in the same
The rest of this paper is structured as follows. Section 2 briefly discusses the theoretical
overview of the transmission channels and the literature on Malaysia. Section 3 discusses
2An earlier application of this methodology can be found in Helliwell and Higgins (1976).
methodological issues relating to the rationale for the selection and ordering of variables,
their transformations, model estimation and the shutdown methodology. All results are
presented in Section 4 and divided into two parts. Section 4.1 investigates whether there
exists a monetary policy transmission process in Malaysia and whether the four transmission
channels identified in this paper are relevant. The core question on the relative importance
of the different transmission channels is answered in Section 4.2. Finally, Section 5 ends with
some concluding remarks, policy considerations and future areas of research.
2 Theoretical Overview of the Transmission Channels and
Literature on Malaysia
This section provides a simple theoretical overview of the transmission channels studied in
this paper and a brief literature review on Malaysia. Using Mishkin’s (1996) instructive
schematic, the interest rate channel can be depicted as follows: M ↑ ⇒ r ↓ ⇒ I,C ↑ ⇒
Y ↑ . An expansionary monetary policy (M) causes a fall in nominal interest rates and, given
price rigidity, a fall in real interest rates (r). Falling real interest rates boost investment (I)
as the required rate of return of a project and the cost of borrowing decline. Similarly,
consumption (C) increases and hence aggregate demand and output (Y ) rise.
The credit channel studied here captures elements of both the bank lending and the
broad credit (balance-sheet) channel for the reason that the variable used, that is, the total
outstanding loans of the banking system, incorporates the features of both the channels.
The bank lending channel works through the supply of bank loans. For instance, an expan-
sionary monetary policy increases the reserves of private banks and hence the pool of loans
(L). Bank dependent borrowers will then borrow to finance their investment and consump-
tion, which boost aggregate demand and output: M ↑
On the other hand, the broad credit channel transmit monetary policy shocks on the ba-
sis of how banks assess borrowers or specifically borrowers’ balance sheets (Bernanke and
Gertler (1995)) – hence, it is also known as the balance sheet channel. In this channel,
an expansionary monetary policy leads to lower nominal interest rates (i) and alleviates
the debt service burden of companies and consumers.
improve, banks become more willing to lend and aggregate demand and output rise. At
the same time, asset prices (Pa) rise, pushing up borrowers’ collateral value (CV) and
increases their net worth, and boosts bank lending and aggregate demand and output:
M ↑ ⇒ ( i ↓ ⇒ CF↑ and Pa↑ ⇒ CV ↑ ) ⇒ L ↑ ⇒ Y ↑ .
According to the exchange rate channel, monetary policy shocks are transmitted via net
exports. An expansionary monetary policy causes domestic real interest rates to decline as-
suming price stickiness (nominal rigidities). This leads to capital outflows and a depreciation
in the domestic currency (E ↑: RM/USD) resulting in cheaper domestic products relative to
⇒ L ↑⇒ I,C ↑⇒ Y ↑ .
As cash-flows of borrowers (CF)
Table 3: Unit Root Tests1
Intercept Intercept & Trend
Variable Pre-Crisis Sample2
Intercept Intercept & Trend
∗and∗∗refer to the 1% and 5% level of significance respectively. Lag differences included in the tests
are chosen automatically based on the AIC.
2Pre-crisis sample starts from 1981:1 to 1997:1.
3Refers to the seasonally adjusted real GDP series.
4The test statistic when a structural break in 1987:1 is incorporated is -3.12 and statistically significant
at the 5% level.
4 shows there are more than one cointegrating relations in the model. These findings are
robust across the different assumptions on the deterministic term, different sample periods
and the choice of lags. Several general observations can be gleaned. Both the assumptions
of intercept, and intercept and linear trend give essentially a similar number of cointegration
relations, while the orthogonal trend assumption gives a slightly lower number. However,
when the optimal lag is chosen, the number of cointegrating relations increases.
Table 4: Cointegration Tests1
Different Deterministic Term Assumptions:
InterceptIntercept & Trend
r = 0
r = 1
r = 2
r = 3
r = 4
r = 5
r = 6
r = 7
r = 8
r = 9
r = 10
r = 11
r = 0
r = 1
r = 2
r = 3
r = 4
r = 5
r = 6
r = 7
r = 8
r = 9
r = 10
r = 11
1The trace statistics are shown. For simplicity, the VAR model used here comprises the 12 variables,
an intercept term and the Asian crisis dummy variable.
∗and∗∗refer to the 1% and 5% level of significance respectively. An asterisk at H0 : r = 0 means the
rejection of the null hypothesis that there is no cointegrating relations in the system; alternatively, the
acceptance of one or more cointegrating relations in the system.
3This assumes that there is a linear trend in the series but not in the cointegration relations.
4Optimal lag is chosen based on the AIC, HQC and SC. The results presented are for orthogonal trend.
The lag is 6 in the case of the full sample, and 4 in the pre-crisis sample.
n.a Not applicable.
Table 5: Lag Order Selection Criteria
∗Indicates the lag order selected by the said cri-
terion. The criteria are based on Chapter 4,
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