Malaysian inflation and the ringgit effective exchange rates : a vector error correction analysis

The paper empirically analyzes the inflationary effects of exchange rate changes for the case of a small open economy, Malaysia, using recent econometric techniques of cointegration and vector error correction modeling. To evaluate the dynamic interactions among the variables in the model, we generate variance decompositions and impulse-response functions. Our findings suggest an inflationary effect of currency depreciation in the long run. Moreover, the variance decompositions suggest quite a sizable fraction of the inflation forecast error variance attributable to exchange rate shocks. Likewise, inflation innovations explain quite substantially, but temporarily, the exchange rate forecast error variance. Lastly, the impulse-response functions substantiate our conclusion that currency depreciation is inflationary and that the inflation shocks have temporary effects on the exchange rate. (Sav Dev/DÜI)