Monetary policy and inflation targeting in a small open-economy

This paper investigates the transmission mechanism of monetary policy and inflation targeting in a small open-economy by using backward-looking of aggregate supply (AS) and aggregate demand (AD) framework. Since September 1998 until July 2005, Malaysia has implemented a currency pegged to the U.S dollar in responding to the Asian financial crisis. However, since the 21st of July 2005 until at present, the Central Bank of Malaysia (CBM) has eliminated pegging with the U.S dollar and moved to the floating exchange rate with basket currencies framework. This new regime has an essential role to be a primary objective of policy in stabilizing exchange rate against its major trading partners, particularly the regional countries. Nevertheless, maintaining the soundness of interest rate is also important to perceive inflation targeting in increasing economic growth. Therefore, by using a quarterly data from 1991:1 to 2006:1, this study has adopted a traditional structural econometrics model (SEM) to examine the role of inflation targeting in monetary policy transmission in a small-open economy, i.e. Malaysia. The findings indicated that output gap is an important variable in forecasting a domestic inflation rate and interest-rates policy is statistically significant in influencing the output gap. Therefore, the choosing of interest-rates as a policy target is vital in controlling the domestic inflation rate.