THE IMPACT OF INTEREST RATE AND EXCHANGE RATE TOWARDS INFLATION AT MALAYSIA

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1 THE IMPACT OF INTEREST RATE AND EXCHANGE RATE TOWARDS INFLATION AT MALAYSIA Hamidah Ramlan 1 Nur Iliyani Binti Mohamed Ruslan Abstract This study investigates which of independent variables have a significant impact and relate towards inflation in the implementation of monetary policy. The dependence is inflation rate and the independent variables are the interest rate and exchange rate. Using secondary data by collected in the World Bank under the International Monetary Fund Malaysia. The instrumentation for data analysis is by using the SPSS. This study found that the exchange rate has a significant impact and relationship with inflation. Furthermore, the interest rate shows that no impact and relationship towards inflation. Keywords: inflation rate, interest rate, exchange rate JHLCB Introduction Malaysia is a small, trade-dependent economy with a higher degree of foreign in both real and financial sector, which is globalization, had significant impact on the operation of monetary policy in the economy. In the last decade, Malaysia was quite a varied in monetary policy, with change in the monetary framework mainly response to global developments. The assessment of the monetary policy is essential in order to make the right decision at the appropriate time (Jose Manuel, 2011). Monetary policy consists of the actions of a central bank, currency board or other committee determine the size, price and rate growth of the money supply, which turn in affects interest rates. Monetary policy is maintain through actions as modifying the interest rate, buying or selling government bonds and change the amount of money banks are required to keep in the ban reverse. Monetary policy should use lean against rapid and excessive increases in asset and the central bank should extract provided by price development on the outlook for output and inflation 1 Lecturer,College of Business & Accounting, Universiti Tenaga Nasional Sultan Haji Ahmad Shah Campus, Muadzam Shah, Tel: Hamidah@uniten.edu.my 142

2 Inflation can be defined as a continuous increase in the general price level of good and services in the economy. Since inflation refers to a continuous increase in the price level, although the price of every product and services are not increasing. Inflation influenced by real gross domestic product, depreciation in foreign exchange and also the supply of money with depreciation sustaining its short run effect in the long run (Imimole and Enoma, 2014) In additional, the interest rate can be defined as a cost of borrowing money. The interest rate is normally expressed as a percentage of the total borrowed. Reduced the nominal interest rate when the inflation rate is high and it raises the nominal interest rate when the inflation rate is low (Million, 2003). The increased interest rate raises the user cost of capital those results in higher production cost. This change raises inflation by shifting the aggregate supply curve to the left side. Also the changing interest rate impact on inflation through influencing the money volume. (Branson, 1979) The exchange rate is the price of one currency in terms of another currency. The exchange rate can be either fixed or floating. The exchange rate is the main issue for consideration under the balance of payment aspect (Akinbabola, 2012). B Imimole, A Enoma (2011) examined the impact of exchange rate depreciation on inflation in Nigeria for the period , the research found that exchange rate, money supply and real gross domestic product are the main determinants of inflation in Nigeria. Implies that the exchange rate depreciation can bring about an increase inflation rate in Nigeria. The purpose of this study is to investigate the impact of interest rate and exchange rate towards inflation rate in Malaysia. Literature Review Many central banks now express their official monetary policy stance in interest rate terms. At the same time, the day-to-day operating objective of central banks has focused more on stabilizing some measure of the short-term interest rate, less on targeting quantities. Where they apply, reserve requirements have tended to become more simplified and less onerous, serving less as a main monetary control instrument, more as a means to make reserve demand more predictable and to buffer short-term interest rate (Corrinne Ho, 2008). The important factors, which influence the area growth, are investment, interest rate, labor wages, and export price (Suharyadi, 2008). With their research, which is exchange rate fluctuation targeting in an open economy, econometric approach. The study shows that the estimated long run model that all the variables, which is the interest rate with exchange rate, were positively significant (Nathan Pelesai Ph.D & Ameagberi, Michael, Audu, 2013). They said that the stabilized of the exchange rate as this would give impacts to the economy. The model they employ incorporates four variables, which is price, money, exchange rate, peg and real GDP. They found that the exchange rate has a strong effect on the inflation rate (Horvath and Maino, 2010). 143

3 With their study about the impact of interest rate and exchange rate towards inflation rate that increase policy maker s accountability and helps to establish their credibility. Not only to central bank know what they are supposed to do or everyone else does too. (Cecchatti et al, 2009) Fernando Alvarez, Robert E. Lucas, and Warren E. Weber (2001) study on interest rate and inflation shows that the central element of the instrument of monetary policy is to be short-term interest rate. The monetary policy should focus on the control of inflation and the inflation can be reduced by increasing short-term interest rate. On the other hand, they have concluded that there is no strong relationship between interest rate and inflation rate (Ghazali, 2003). Another study is result shows that the short run relationship between exchange rate and inflationary rate is sustainable in the long run. The satisfactory speed of adjustment indicated by the error correction model further supports this long run relationship. The result showed that both domestic and imported inflation appreciated (Oriavwote, Eshenake, 2012). However, they examine the relationship between inflation and interest rate for 114 economies over a 45-year period using monthly data. Interest rate and inflation are found to exhibit a long run equilibrium relationship for numerous economies, states (Reimers, 2006). Data and Methodology This study plan will involve the gathering of information about the interest rate and exchange rate towards inflation. This study is using the secondary data for the research and time-series data, which is yearly basis from 1987 until The data resources are from the World Bank and International Monetary Fund (IMF). In the proposed study, two instruments will employ to measure two independent variables (interest rate and exchange rate) and one dependent variable (inflation rate). Hypothesis: H1: There is a significant impact between interest rate and exchange rate towards inflation rate. H2: There is a significant relationship between interest rate and exchange rate towards inflation rate. The regression model is as follows: Y=a0 + β1 IR + β2 ER + ɛ 144

4 Where: Y: Dependent Variable (inflation rate) a0: Constants Value β: Regression Coefficients IR: Inflation Rate ER: Exchange Rate ɛ: Residual Term Findings and Analysis Descriptive Analysis INFLATION RATE EXCHANGE RATE INTEREST RATE MEA N STD. DEVIATION N Table 1 Descriptive Analysis Table 1 above is the result of descriptive analysis from SPSS, which shows that the mean and standard deviation of each variable. Means inflation is calculated as while the standard deviation is For the value of Mean and Std. deviation of exchange rate is only and respectively. Lastly, the lowest mean for interest rate towards inflations is and the standard deviation is From the table, the differences of mean and standard deviation between exchange rate and interest rate are only and respectively. 145

5 The Result of Linear Regression Test Model R R Square Adjusted R Std. Error of Square the Estimate a a. Predictors: (Constant), Exchange Rate, Interest Rate Table 2 Model Summary Table 2 shows the model summary of the study. In this model summary of findings, the value of R is 0.713, which mean 71.3% of the dependent variable is explained through independent variables. It means there is a positive significant relationship between two variable because of the level or square must less than 0.5, which is 50%. The coefficient of correlation the sample data measures the strength, direction of a linear relationship between two variable. The range of the coefficient of relation is from -1 to +1. If there is a strong positive linear relationship between two variables, the R will be close to +1. However, if there is a strong negative linear relationship between the variable, the value of R will be close to -1. ANOVA a Model 1 Regression Residual Total Sum of Squares df Mean Square F Sig b a. Dependent Variable :Inflation rate b. Predictors: (Constant), Exchange Rate, Interest Rate Table 3 ANOVA From the table 3 shows ANOVA of the study. From the table, this study found that the significant amount is must below than 0.05 and the significant on the table is Therefore, there is statistically significant impact of independent variable, which is interest rate and exchange rate with dependent variable, inflation rate. 146

6 Table 4 Coefficients Table shows the coefficients of the findings. The value B states whether the value positive or negative effect towards dependent variables while the significant value below 0.05 means the dependent variable is significant. From the table, the result indicates that the exchange rate has a positive impact and has a significant relationship towards inflation. Meanwhile, the result of interest rate no significant impact with inflation. The result is 0.404, which is more than significant level The result supported by Ghazali (2003) has concluded that there is no strong relationship between interest rate and the inflation rate. Interest rate Exchange rate Inflation Interest rate Exchange rate Inflation rate Pearson correlation Sig. (2-tailed) Pearson correlation Sig. (2-tailed) Pearson correlation Sig. (2-tailed) Table 5 Correlation A positive correlation exists among the variables between exchange rate and inflation, but a negative correlation between interest rate and inflation. Some with moderate correlation and some with the very low correlation as shows in table 5. The result shows, there is a positive correlation between exchange rate and inflation, the significant level is and the Pearson correlation is

7 This result support by Imimole and Enoma (2011) looked into the possible effects of drop in rate of exchange rate of inflation in Nigeria between 1986 and It was found that inflation influenced depreciation in foreign exchange rate and also the supply of money with depreciation sustaining its short run effect in the long run and in a positive relationship. While the correlation between interest rate and inflation us relatively higher than the exchange rate. The results in the interest rate is and the Pearson correlation is and that result is no relationship correlation. Conclusion and Recommendation This study examines the impact of each independent variable to the dependent variable, which found different result of each independent whether positive or negative. The findings shown exchange rate has a positive impact on inflation supported by Oriavwote and Eshenake (2012). While interest rate has negative impact on inflation supported by Fernando Alvarez (2001). Based on the regression Analysis the empirical study reject H(1) from the variables interest rate which indicate there is no positive impact between interest rate towards inflation. From the result, the interest rate has negative impact on inflation, While reject H(2) also from interest rate which indicate there are no relationship between interest rate and inflation supported by Ghazali (2003) and Herwatz and Reimers (2006). This study has to accept H (1) from the exchange rate, which there is a positive impact exchange rate towards inflation. Finally yet importantly, the result from the study had shown there a relationship on exchange rate towards inflation. Which mean the study to accept H(2) from the variable, supported by Akinbabola (2012). The study could be enhanced by including using more variables, such as gross domestic product (GDP), money supply (M1, M2, M3) or economic growth. The scope of study could be expanded to the data frequency, for example increase of the observation years. This study should be continued to ensure the implementation of monetary policy in Malaysia are run to be better. It also should be use other factor variable and use other method. 148

8 References Akinbabola (2012) Exchange rate and Inflationary rate: Evident from Nigeria International Journal of Economic and Finance, page 80 Branson (1979) The Relationship between Interest rate and Interest Changing: Long Term Interest Dynamic Princeton university, page 3 Cecchatti et al (2009), Bean (2009) Monetary Policy and Asset Prices in Small Open Economy The School of Economis, page 4 Corrinne Ho (2008) Implementing Monetary policy in 2000s Monetary and Economic Department, page 2 Dalina Amonhaemanon, Marc J.K. De Ceuster, Jan Annaert, Hau Le Long(2013) The Inflation-hedging Ability of Real Estate Evidence in Thailand: Procedia Economics and Finance, Volume 5, pp Dilek Teker. Elcin aykac, Alp,oya Kent (2012) Long run Relation between Interest rate and Inflation: Evidence from Turkey Journal of Applied Finance and Banking, page 42 Fernando Alvarez, Robert E. Lucas, and Warren E. Weber (2001) Interest rate and Inflation The American Economic Review, Vol 91, No 2, Fisher (2012) Long run Relation between Interest rate and Inflation: Evidence from Turkey Journal of Applied Finance and Banking, page 41 G.Cecchetti Stephan (2011) The Implementation of Monetary Policy Lesson From The Crisis and Challenges for Coming Years SEASON-CEMLA Conference, page 14 Ghazali (2003) A Long Money Test to the Long Run Fisher Effect the G7 Countries Applied of Financial Economics, page 3 Hanif (2010), Salman Sheikh (2010), M.Nadim (2010) Central Banking and Monetary Management in Financial Environment Journal of Independent Studies and Research, page 2 Herwarts and Reimers (2006) Long run Relationship between Interest rate and Inflation Journal of Applied Finance and Banking, page 43 Horvath and Maino (2010) The Impact of Monetary Policy and Exchange rate Journal economic and Business, page 268. Hui Ding, Jaebeom Kim (2017) Inflation-targeting and real interest rate parity: A bias correction approach Economic Modelling, Volume 60, pp Imimole and Enoma (2014) Exchange rate and Inflationary rate: Evident from Nigeria International Journal of Economics and Finance, page 81 Jose Manuel (2011), Gonzales Paramo (2011) The Conduct of Monetary Policy SEACEN- CEMLA conference, page 38 Michael Abrahams, Tobias Adrian, Richard K. Crump, Emanuel Moench, Rui Yu (2016) Decomposing real and nominal yield curves Journal of Monetary Economics, Volume 84, pp Million (2003) The Relationship between Interest rate and Inflation International Conference on Economic Policy Modeling, page 3 Mordi (2012) The Changing Structure of the Nigerian Economy and Implication for Development Realm communications ltd. Lagos, page Nathan Pelesai Ph.D & Ameagberi, Michael, Audu (2013) Exchange rate Fluctuation and Inflation Targeting in Open Economy European Journal of Accounting Auditing and Finance research, Page

9 Oriavwote, Eshenake(2012) Exchange rate and Inflationary rate: Evidence from Nigeria International Journal of Economic and Finance, page 82 Suharyadi (2008) Fiscal and monetary Development of Indonesia plantation Economic Journal of Merging Market, page 135 Sumru Altug, Cem Çakmaklı (2016) Forecasting inflation using survey expectations and target inflation: Evidence for Brazil and Turkey International Journal of Forecasting, Volume 32, Issue 1, pp Svensson and Lars E.O (2010) Inflation Targeting NBER Working, 150