UNIVERSITI PUTRA MALAYSIA

THE TRANSMISSION MECHANISMS OF INFLATION: AN EMPIRICAL STUDY ON THE ASEAN ECONOMIES

CHENG MING YU

FEP 1999 8

THE TRANSMISSION MECHANISMS OF INFLATION: AN EMPIRICAL STUDY ON THE ASEAN ECONOMIES

CHENG MING YU

DOCTOR OF PHILOSOPHY UNIVERSITI PUTRA MALAYSIA

1999

THE TRANSMISSION MECHANISMS OF INFLATION: AN EMPIRICAL STUDY ON THE ASEAN ECONOMIES

By

CHENG MING YU

Thesis Submitted in Fulfilment of the Requirements for the Degree of Doctor of Philosophy in the

Faculty of Economics and Management U niversiti Putra Malaysia

May 1999

SPECIALLY DEDICATED TO :

MY LOVE MOM AND DAD

& MY DEAR SISTERS: CHAIM YU, WEN YU, YEE YAR AND HOU YEA

& MY BROTHERS-IN-LAW: CHEN THONG AND SIM GUAN

ACKNOWLEDGEMENTS

My debts to many individuals can be warmly acknowledged but never fully

recompensed. I wish to express my deepest appreciation and profuse thanks to the

Chairman of my thesis committee, Dr. Tan Hui Boon, who provided years of

unconditional, personal support and encouragement, insightful suggestions and

guidance that made it possible for me to successfully complete this study. To her, I

owe a debt of gratitude.

An equal large debt is owed to the members of the thesis committee, Assoc.

Prof Dr. Ahmad Zubaidi, Assoc. Prof Dr. Mad Nasir and Assoc. Prof Dr. Zakariah,

thanks for their enthusiasm and valuable guidance and comments in the writing of this

thesis.

My thanks also go to lecturers in UPM for their direct and indirect assistance,

advice and support. Special thanks are due to Prof Dr. Ghazali, Prof Dr. Nik

Mustapha, Assoc. Prof Dr. Kuperan, Prof Mohd Yusof, Prof Ariff of Monash

University, Australia, Prof Annuar and Dr. Shamsher for their useful comments and

suggestions.

Special recognition is due to Dr. Ashley for his very useful comments during

the course of this study. An immense appreciation is also due to my uncle, Mr. Hank

Lee, economic specialist of American Institute in Taiwan and friend, Dr. Lin Chin

iii

Ming of APEC Study Center in the Taiwan Institute of Economic Research, who

greatly helped me throughout my work on this thesis with ideas, guidance and

continuous criticisms.

Thankful to the financial support provided by the Yayasan Sarawak Tunku

Abdul Rahman Foundation, who financed my entire education in the Ph.D. program.

Great appreciation is due to Puan Rabidah, Puan Zaiton, Puan Arbaiyah, Puan

Faridah, Puan Napsiah and all the staffs of the Graduate School for their helps during

the process of completing this thesis. Also to Kak Roby, the lab assistant of the

Faculty of Economics and Management, for her kindness to let me used the computer

facilities in the faculty.

To all my friends, especially Shu Ting, Law, Wai Kit and Meng Keat, Jo Ann,

Jahan, Taufiq, Huson, Ahmed, Indah, Amna and Ahlam not only for their help during

this study, but also for the personal warmth they have injected into this arduous

process.

My final and greatest debt is to my family - my dear mom and dad, my sisters

and brothers-in-law. The list of sacrifices they have made in order for me to complete

this study is long. Their support and love have been wonderful.

iv

TABLE OF CONTENTS

Page

ACKNOWLEDGEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . 111 LIST OF TABLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . YI11 LIST OF FIGURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x ABSTRACT . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Xl ABSTRAK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Xl11

CHAPTER

I OVERVIEW OF THE STUDY ........................... . 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

The Geographic Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 The Study of the ASEAN Economies . . . . . . . . . . . . . . . . . . 2 The Study of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Statement of Problem . . . . . . . . . .... . . ... . . . . . . . .. . . .... . . . . . . . . 9 Objectives of the Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Significance of the Study . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . 14 Organisation of the Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

n THE ASEAN ECONOMIES . ... . . ... . .. . . . . .. . . . . . . . . . ..... 18 History and Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Malaysia . . . . . . ..... . . . . . . ..... . . ......... . ...... . . ........ . . .. .. 38 The Philippines . . . . . . . .... . . . . . . .. . . . . . . . . .. . . . ..... . .... . ..... 44 Singapore . . . . . .. . . . . . . . . . .. . . . . .. . . . .. . . . . . . . . . . . . ...... . . . . . ... 48 Thailand .. . . . . . . . . .. . . . . . ..... . . ... . . ....... . ... ... . .... . . . . . . .. 56

ill THE STUDY OF INFLATION . . . . . . . .. . . . . . . . . . . . . . . . . . . . 64 Introduction ....... . . . ... .... . . .. . . . . . . . . . .... . .. . . . . . ... . ... . . . 64 Definition of Inflation .................. . . ...... . . . . . . ......... 64 Measurement ofInflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

The Laspeyres Price Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 The Paasche Price Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Indicators of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 The Consumer Price Index (CPI) . . . ..... ... . . . . . . . . .... 70 The Producer Price Index (PPI) . . . .. . . .... . . .. ... . . . . . . 7 1 The GNP Implicit Price Deflator ................ . . ........ . 72

The Nature and Causes of Inflation .. . . ....... . ........... . . 79

v

The Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 The Demand-Pull Theory ofInflation . . . . . . . . . . . . . . . ... 83 The Cost-Push Theory ofInflation ...... . . . . .. . . . . . . . . . 84 The Monetarist Model ofInflation . . . . . . . . . . . . . . . . . . . . . 86 The International Inflation Model ............. . . . . . ... . 87

IV REVIEW OF LITERATURE . . . . . . ... . ..... . .. . . . . . . . . . .. . . 92

v

VI

Review of Empirical Studies on Inflation . . . . . . . . . . . . . . . . . . 92 Review of Empirical Studies on International Aspects of Inflation . . . . . . . ... . . . ..... . .... . . . . . . .. . . . .. . . . . .. . . . . . . . . . . . . 104

METHODOLOGY .......................................... . The V AR Technique . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Introduction to V AR .................................... . Statlonanty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vector Error Correction Model (VECM) . . . . . . . . . . . . . . Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impulse Response Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variance Decomposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Empirical Models and Estimation Procedures . . . . . . . . Model Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Estimation Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Diagnostic Checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Consumer Price Index (LF) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money (LM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Rate (IR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income (L Y) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Private Consumption (LC) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Government Expenditure (LE) . . . . . . . . . . . . . . . . . . . . . . . . . . Exchange Rate (LX) . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade Balance (L T) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Inflows (LK) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Rest of the ASEAN's Inflation (LAF) . . . . . . . . . . . . The Rest of the World's Inflation (LWF) . . . . . . . . . . . . . .

RESULTS AND DISCUSSIONS ......................... . Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Estimated Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Unit Root Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cointegration Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

vi

1 17 1 18 1 18 12 1 127 136 1 39 146 148 149 1 50 1 58 163 165 167 169 169 170 170 170 171 171 171 172 173 174

175 176 179 180 187

Vector Error Correction Modeling (VECM) . . . . . . . . . . 192 Diagnostic Checking . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

vn SUMMARY AND CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . 242 Discussions and Implications of the Findings . . . . . . . . . . . . . . 246 Suggestions for A More Effective Inflation Management in ASEAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... .. 256 Limitations of the Study and Recommendations for Further Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258

BmLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . 260

APPENDIX A The Interpolation Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 B The Seasonal Scalling Factors . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 C The Graphic Presentation of Time Series . . . . . . . . . . . . . . . . . . . ... . 280 D The Residuals Correlation Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285

VITA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

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Table

2. 1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

3.1

3.2

3.3

3.4

3.5

6. 1

6.2

6.3

6.4

6.5

LIST OF TABLES

Page

GDP Per Capita (US$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Intra and Inter ASEAN Trade (US$ million) 22

The Compositions of ASEAN Imports and Exports (million US$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Basic Economic Data for Indonesia . . . . . . . . . . . . . . . . . . . . . . . . 37

Basic Economic Data for Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . 43

Basic Economic Data for the Philippines . . . . . . . . . . . . . . . . . . 49

Basic Economic Data for Singapore . . . . . . . . . . . . . . . . . . . . . . . . 55

Basic Economic Data for Thailand . . . . . . . . . . . . . . . . . . . . . . . . . . 60

The Weights ofCPI by Major Categories in Indonesia . . . 75

The Weights of CPI by Major Categories in Malaysia . . . . 77

The Weights of CPI by Major Categories in the Philippines . . , 78

The Weights of CPI by Major Categories in Singapore . . . 78

The Weights ofCPI by Major Categories in Thailand . . . . 79

Lag Lengths Selection, Constant, Trend and Seasonal Dummies Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

Unit Root Test Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

Unit Root Test Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Unit Root Test The Philippines

Unit Root Test

184

Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

viii

6.6

6.7

6.8

6.9

6. 10

6. 1 1

6. 12

6.13

6. 14

6. 1 5

6 . 16

6 . 17

6. 18

6 . 19

6.20

Unit Root Test Thailand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Johansen Cointegration Analysis for CPIs of Five ASEAN Countries (Model One) . .. . . . . . . . . . . . . . . .. . . . . . . . . . . . 189

Johansen Cointegration Analysis for CPI of Each ASEAN Country and The Rest of the World (ROW) . . . . . . 190

Johansen Cointegration Analysis on Model Three 19 1

Estimated V AR Coefficients in VECM Model Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Variance Decomposition Indonesia ................ . . . ....................................... . ....... . . . 202

Estimated V AR Coefficients in VECM Model Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Variance Decomposition Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1 1

Estimated V AR Coefficients in VECM Model The Philippines . . . ... ..... . . . . . . . . . . . . ... . . . . . . . . . .. . . . . . . . . . . . . 218

Variance Decomposition The Philippines ....... . . . . . .......... . . . . .... . . . . ....... .. . .. . . .... . .. . . . . . 220

Estimated V AR Coefficients in VECM Model Singapore . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226

Variance Decomposition Singapore ....... . . ......... . . . . ....... . ... . . . .. . . . . .... . . ... . . .. . ........... . 228

Estimated V AR Coefficients in VECM Model Thailand .. . . . . . . ... . . . . . . . .. . . . . . . . . . . . .. . . . . . . . ' " ' " . . . . . . . . . . . 233

Variance Decomposition Thailand .... . . . . . ..... . . . . . . ...... . . . . . .. . . . . . . . . . ... . . .... . . . .. . . . . . . . . . . . . . . 235

Results of Diagnostic Checking on VECM . . . . . . . . . . . . . . . . 239

ix

LIST OF FIGURES

Figure Page

2. 1 GDP Growth Rates and Inflation Rates for the ASEAN Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . 61

6. 1 The Causal Relationships with Inflation Variable Indonesia . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

6.2 Response to one S .D . Innovations Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . . . . . . . . . . . , . . . . . . 203

6.3 The Causal Relationships with Inflation Variable Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . . . . . . 210

6.4 Response to one S .D. Innovations Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 12

6.S The Causal Relationships with Inflation Variable The Philippines . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 2 19

6.6 Response to one S.D. Innovations The Philippines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 1

6.7 The Causal Relationships with Inflation Variable Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ' " . . . . . . . . . . . . . . . , . . . . . . 227

6.8 Response to one S.D. Innovations Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . ' " . . . . . . . . . . . . . . . . . . . . . . . . . . 229

6.9 The Causal Relationships with Inflation Variable Thailand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ' " . . . . . . . . . . . . . . . . . . . 234

6. 10 Response to one S.D. Innovations Thailand . . . ... . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . . . . . 236

6. 1 1 The CUSUM Test Results for the ASEAN Economies . . . . 238

x

Abstract of dissertation presented to the Senate ofUniversiti Putra Malaysia in fulfilment of the requirements for the degree of Doctor of Philosophy.

THE TRANSMISSION MECHANISMS OF INFLATION: AN EMPIRICAL STUDY ON THE ASEAN ECONOMIES

By

CHENG MING YU

May 1999

Chairman: Tan Hui Boon, Ph.D.

Faculty: Economics and Management

Maintaining low and stable inflation has been the primary goal of most

countries, particularly for the fast growing developing countries. Vast great inflation

theories, from Classical, Keynesian, Monetary to Structural, carrying different

banners and offering different evidence on the causes of inflation. It is of utmost

importance to correctly identify the causes of inflation in each economic setting as

wrong diagnosis of the nature of the problem will lead to the application of

inappropriate cures that might hurt the economy.

This study, whenever possible, takes the effort to capture the ideas of major

inflation theories in a single dynamic inflation model. An eleven-equation set up with

eleven variables in each equation is used for each five ASEAN countries. The

ASEAN in this study refers to five original members of ASEAN, namely fudonesia,

Malaysia, the Philippines, Singapore and Thailand. The primary mission of this study

is to analyze the relative importance of factors that significantly contributed to

xi

inflation in each of the ASEAN country. This study also aimed to examine the

existence of international as well as intra-ASEAN transmission of inflation to these

countries.

The objectives of the study were achieved by the estimation of Vector Error

Correction Model (VECM) and the analysis of impulse response function as well as

variance decomposition for each country. The data for the study consists of quarterly

observation from 1973:1 to 1 997 :11.

The results of the study revealed that for the ASEAN economies that showed

high and stable economic growth for a sustained period, namely Singapore and

Malaysia and which had adopted consistent policy in the country, tended to have

relatively low and stable inflation rates. Due to the openness of the countries, external

factors such as the rest of the world's inflation rates and the rest of the ASEAN's

inflation as well as the exchange rate variable are relatively more important in

explaining inflation in these two countries. On the other hand, Indonesia and the

Philippines which were burdened by huge foreign debts and had took up inconsistent

policy mix to spur the growth in the economy had generally experienced high and

variable inflation rates. External and internal factors are important in generating

inflation in these two countries. In Thailand, the inflationary analysis was somehow

unsteady. The findings could be attributed to the structural shifts arising partly from

trade and financial liberalisation in the country, particularly at the end of 1 980an.

xii

Abstrak disertasi yang dikemukakan kepada Senat Universiti Putra Malaysia sebagai memenuhi keperluan untuk ijazah Doktor Falsafah

MEKANISASI PENGANTARAN INFLASI: SATU KAJIAN EMPIRIKAL BAGI EKONOMI-EKONOMI ASEAN

Oleh

CHENG MING YU

Mei 1999

Pengerusi: Tan Hui Boon, Ph.D.

Fakulti: Ekonomi dan Pengurusan

Mengekalkan inflasi pada tahap yang rendah dan stabil adalah tujuan asas bagi

kebanyakan negara, terutamanya bagi negara yang pesat membangun. Terdapat

pelbagai jenis teori inflasi, dari Klasikal, Keynesian, Kewangan ke Struktur,

membawa bana yang berlainan dan menawarkan bukit yang belainan bagi sebab-

sebab berlak.unya inflasi. Usaha-usaha bagi mengesahkan asas inflasi dengan betul

bagi setiap ekonomi adalah amat penting kerana diagnosi yang salah tentang asas

masalah inflasi akan membimbing kepada penggunaan cara pembetulan yang tidak

sesuai yang mungkin mengancam pembangunan ekonomi negara.

Kajian ini, apabila sesuai, mengambil usaha untuk merangkumi idea-idea

inflasi utama ke dalam satu model inflasi dinamik. Satu sistem yang terdiri daripada

sebelas persamaan dengan sebelas pembolehubah dalam setiap persamaan telah

dibentuk bagi setiap lima negara ASEAN. ASEAN dalam kajian ini merujuk kepada

lima ahli asas, iaitu Indonesia, Malaysia, Filipina, Singapura dan Negeri Thai. Misi

xiii

utama kajian ini adalah untuk menganalisa kepentingan relatif faktor-faktor yang

menyumbang kepada inflasi di setiap negara ASEAN. Kajian ini juga bertujuan

untuk memeriksa kewujudan pengaruh-pengaruh antarabangsa dan ASEAN di

negara-negara 1ll1.

Objektif-objektic kajian ini dicapai dengan menganalisa VECM 01 ector Error

Correction Model) dan fungsi tindakbalas impuls dan juga dekomposasi variasi. Data

yang digunakan terdiri daripada data suku tahunan dari 1973:1 ke 1997 :TI.

Keputusan analisa menunjukkan bahawa negara ASEAN yang mengalami

pembangunan yang pesat dan stabil untuk jangka masa yang panjang serta

mengarnalkan polisi yang konsisten, iaitu Singapura dan Malaysia, cenderung

mempunyai kadar inflasi yand lebih rendah and stabil. Disebabkan oleh kebukaan

ekonomi bagi kedua-dua negara ini, faktor luaran seperti inflasi dunia dan inflasi

negara ASEAN lain dan kadar tukaran wang adalah lebih penting dalarn menerangkan

inflasi di kedua-dua negara ini. Di sebaliknya, bagi negara yang dibebankan dengan

hutang luaran yang tinggi dan telah mengarnalkan polisi yang tidak konsisten untuk

merangsangkan pembangunan negara, Indonesia dan Filipina secara keseluruhannya

mengalami kadar inflasi yang lebih tinggi dan tidak stabil. Faktor-faktor luaran dan

dalarnan adalah sarna-sarna penting bagi negara-negara ini. Di Thailand, analisa

inflasi adalah tidak stabil. Ini adalah disebabkan oleh pembangunan ekonomi yang

tidak stabil akibat daripada peralihan struktur pada akhiran 1980an.

xiv

CHAPTER I

OVERVIEW OF THE STUDY

Introduction

The Geographic Coverage

The ASEAN1 is currently comprising of ten countries, namely Indonesia,

Malaysia, the Philippines, Singapore, Thailand, Brunei and lately of Vietnam,

Myanmar, Laos and Cambodia which are all on the southeastern rim of Asia.

However, the focus of this study will be on the major, fast growing and dynamic

developing countries in the ASEAN, which consists of the economies of Indonesia,

Malaysia, the Philippines, Singapore and Thailand . Other members of ASEAN will

not be considered because of the lack of economical statistics and/or prominent

economics performance during the period of study . For the sake of convenience and

consistency, unless otherwise stated, the "ASEAN" in this study refers to these five

main economies in ASEAN, namely Indonesia, Malaysia, the Philippines, Singapore

and Thailand.

The ASEAN (Association of Southeast Asian Nations) was establish in 1 967 to enhance the cooperation among member nations.

I

2

The Study of the ASEAN Economies

The ASEAN economies have been the centre of the study because these

economies have undergone dynamic changes in their economic structure as well as

pattern of economic growth for the last three decades. Also, these countries cover a

fairly large range of average inflation rates in the sample period, which varies from a

low level of four per cent in Singapore and Malaysia to over ten per cent in the

Philippines and Indonesia.

Several ASEAN econOlmes have displayed strong capacity of dynamic

growth, with many having experienced high growth for a sustained period, such as

Singapore and Malaysia, which have continually maintained an average growth rate of

over seven per cent for the period between late of 1 980s and mid- 1990s . In general,

the growth per capita GDP averaged over four per cent in the ASEAN countries

between 1 970 and 1 996, compared with less than two per cent in other developing

economies and 2.6 per cent among the industrial countries (World Development

Report, 1996).

Rapid and significant increased in the interdependency among the ASEAN

economies and the rest of the world in the form of trade, investment, capital and

technology co-operation have led to the strong growth performance in the region.

Efforts to improve the macroeconomics environment in addition to trade and financial

liberalisation have brought about a closer link between these ASEAN countries and

3

also the linkages between ASEAN with the rest of the world. As a consequence,

domestic economical policies have become more interrelated with external sector

policies . Therefore, it is more appropriate to analyse the domestic macroeconomics

problems in these countries in the context of open economy instead of closed and

isolated economy as had been done in most studies .

The exemplary performance of many ASEAN economies for a sustained

period has been the basis for a large and varied literature, much of which explores

reasons for the high growth that draws lessons for other countries that would like to

follow suit . A surprising aspect of this literature is the lack of study on the maturation

of the ASEAN miracle . The sustainability of the ASEAN miracle is being questioned

recently as the region's economies are buffeted by problems. The sharp export

slowdown in 1996, financial woes in Indonesia and Thailand, and the very recent

currency turmoil and growth crisis affecting all ASEAN countries raised the question

of the sustainability of the rapid growth in the ASEAN economies .

It is now widely accepted that a stable macroeconomics framework (which

generally means low inflation) is a necessary condition for sustainable economic

growth . Much striking empirical evidence supports the view that a stable

macroeconomics framework is conducive to growth. In Latin America, the

restoration of budget discipline and the reduction of inflation preceded the recovery of

economic growth in Chile and Mexico . On the contrary, the lasting growth crisis in

Brazil was coincides with high inflation punctuated by stabilisation attempts and

4

continued macroecononucs instability (Fischer, S., 1 993). All countries today,

whether they are developed or developing, faced an inflationary pressure. However,

inflation is always a problem that mostly concerned economists and policy makers in

the fast growing developing economies, especially the ASEAN economies, in spite of

the fact that all this while, the region has managed the inflationary pressures quite

well. As a matter of fact, amidst the obvious strains from heated economic

development, the ASEAN countries have been able to maintain single or low double­

digit inflation rates in average in the sample period. The worry over inflation is due

primarily to the general view that generating inflation is easier than stopping it and

also, maintaining low inflation is less costly than regaining it once it has surged.

There is, therefore, a good reason and timely to examine the issue of inflation in this

region. Better understanding of the transmission mechanisms of inflation in this region

provides a better understanding of the origin as well as the generation of inflation, and

hence promote a more proactive policy to curb inflation.

The Study of Inflation

Inflation has been the concern of the study because inflation is costly and is

widely viewed as a social disaster, although the degree of its seriousness is debatable .

The effects of inflation are so pervasive that almost everyone is concern about

inflation. When asked about the greatest problem confronting them, most people refer

to inflation and some of them even agree that it has graver consequences than

unemployment and other domestic problems (Katona, 1 983).

5

Virtually, why do we so worry about inflation? The reason why inflation has

been the focus of discussion is that its root cause has not really been tackled so far .

Theoretical and empirical researches on the causes and the processes of inflation

occupied a prominent place in macroeconomics literature . Despite the enormous

growth and diversity of inflation literature, a precise identification of the underlying

causes of inflation remains elusive . This probably due to the fact that inflation appears

to be an empirically observable phenomenon that varies greatly both across countries

and over time. Apart from that, the complexity of the analysis increased as we

venture beyond the domain of closed economies, since there arises a need to specifY

clearly the international transmission of price and other macroeconomics disturbances

that might affect domestic prices .

In the real world, prices do not rise as if lifted by an invisible hand. They are

raised by formal and explicit managerial decision made by a few influential groups of

people . In explaining the nature of inflationary process, demand and cost are always

thought as the roots in transmitting inflation while the growth of money supply is the

main reason for inflation in the longer term. However, the actual causes of inflation

may not be similar everywhere. It may be different under different government

policies, different economic environment or different stages of a nation's economic

and social development . Therefore, any attempt to unravel the causal factors in the

generation and propagation of inflation is bound to open a "paradox's box" of rival

theories .

6

For policy makers, inflation is always a problem that needs to be taken care of.

Yet, government attempts to control inflation have not always been successful. The

failure may be attributed to the wrong diagnosis of the nature of the problem, leading

to the application of inappropriate cures. Essentially, economists have advanced a

variety of diagnoses of the causes of inflation, which have provided the base for

various policy prescriptions. There are basically two schools of thought . First, the

causes of inflation are to be found at the world rather than at the individual economy

level. Henceforth, to handle the problem of inflation, it requires common and

integrated international policies. Second, the causes of inflation should be sought

within the particular structure of each individual economy and each country should

adopt such policies as are appropriate to contain its own special inflationary

pressure8.

Concern about inflation comes forth also due to the fact that inflation,

especially unanticipated inflation is detrimental . To the layperson, inflation means the

shrunk in the value of money used for purchasing goods and services . For the society

as a whole, inflation creates problems in the functioning of the economy. According

to Davis (1991), the effects of inflation can be broadly divided into five general

groups. The first kind of the adverse effect is the so called "menu costs" and "shoe

leather costs" . "Menu costs" are extra costs associated with repricing, including the

costs of printing new menus or distributing new catalogues. The "shoe leather costs"

2 Refer Zis, G. (1993) "Inflation: an international monetalY problem or a national social phenomenon" in Inflation in Open Economies.

7

refer to costs incurred as a result of more frequent move to banks . As a result of

higher inflation and hence higher interest rates, people tend to hold less cash, so they

must go more often to bank to obtain cash by making withdrawals from savings

accounts and other interest-paying assets. The inconvenience and loss of productive

time that people suffer constitute the "shoe leather costs . "

The other inflationary consequences as suggested by Davis included distortion

on the allocation of resources and output, effect on the efficiency of the pricing

system as a signalling device and effect on income distribution from savers (or

creditors) to borrowers (or debtors) as well as effect on social and political stability .

Unanticipated inflation contorts the price signals in the market and introduces noise

into the system with the result that economic agents use up a lot of time and resources

to cope with inflation . Thus a result of inflation is that the rate of growth of the

natural level of output is reduced below what it would be in an inflation-free

economy.

While a move towards equality is often reckoned necessary for the economic

and political stability of many developing countries, especially the fast growing

developing ASEAN countries, inflation worsens the income distribution pattern. At

certain level, inflation puts a strain on the social order as it undercuts the perceived

fairness and predictability of economic outcomes. Many empirical evidences have

shown that inflation was partly responsible for much political unrest in many

countries, especially in the fast growing developing countries . A very recent incident

8

of riots in Indonesia as a result of rising prices is the most concrete example to

support the risk of inflation to the stability of a country.

In view of the damaging effects of inflation on the progress of an economy,

maintaining low inflation has been the primary goal of most countries, especially for

fast growing developing economies. Jarrett and Selody (1982) in a study on inflation

found that a one per cent decline in inflation was associated with a permanent rise in

productivity of 0.38 per cent in Canada. As productivity rises, so does standard of

living, which is the ultimate goal of any economic policy. In addition, low inflation

tends to coexist with low relative price variability and inflation uncertainty (Hess and

Morris, 1996). Caporale and McKiernan (1997) by employing a GARCH model finds

a positive and significant relationship between the level and variability of inflation in

which high inflation leads to more variable inflation. An economy tends to functions

better when aggregate prices, as measured by the CPI for example, are steady rather

than volatile. This is for the reason that price stability allows economic decision­

makers, including businesses, investors and consumer to better assess shifts in the

demand and supply for individual goods. This, in tum, encourages a faster and more

optimal allocation of scarce economic resources. On the other hand, price instability

has disruptive effects on economic decisions. It forces businesses and individuals to

spend time and money predicting future prices and hedging against unanticipated

inflation. Because of inflation, economy tends to operate less efficiently. Feldstein

(1983) found that a reduction in inflation of two percentages' points raises the level of

9

GDP by one per cent. As inflation falls, tax distortions stemming from higher inflation

also fall, thus raising savings and hence investment and output.

However, not everyone is thinking that the harm done by inflation is so

significant. Tobin (1972), for instance, has generally perceived that inflation is greatly

exaggerated as a social evil. Several analysts contend that maintaining low inflation is

too costly and the benefits too elusive (Krugman, 1996; Dornbusch and Fischer,

1991). Attempts to reduce the inflation rates, according to these authors, usually

accompany by a reduction in the growth rate of nominal GDP, which is likely to cause

a temporary drop in output and an increase in unemployment. Okun (1974) surveyed

a variety of econometrics evidence and reached the pessimistic conclusion that the

inflation process in the post-war United States is so inertia prone that the cumulative

sacrifice of ten per cent of a year's GNP would be required to achieve a permanent

one per cent point reduction in the inflation rate. Therefore, many economists do not

regard the benefits of lower inflation as worth the sacrifice of lost output and jobs

necessary to achieve it. The very different and contradicted opinions on the effects of

inflation opened up a question for extended investigation.

Statement of Problem

Inflation has been considered as one of the major problem in the management

of macroeconomy. It creates detrimental effects in the functioning of the economy.

Yet, a precise identification of the underlying causes of inflation remains elusive so far