A structural modeling of exchange rate, prices and interest rates between Malaysia-China in the liberalization era

This study constructs a structural system that allows for possible interactions between the goods and capital markets for Malaysia vis-à-vis China in the liberalization era (1994: Jan to 2011: June). It encompasses the joint hypothesis of Purchasing Power (PPP) and Interest Rate Parity (IRP) conditions in the presence of I(1) exogenous variables. Advanced econometric procedures including the structural VARX, VECX*, over-identifying restrictions, bootstrapping, persistent profiles and generalized variance decomposition are utilized in the analyses. The finding upholds support for both PPP and IRP, when exchange rate regime and structural breaks of Asia crisis and subprime crisis are taken into accounts. Despite the direct imported inflation, exchange rate also plays a significant role in the price transmission mechanism. And, Malaysian maintains the relative monetary autonomy against China in short run, but the price channel will affect the extent of IRP condition. Lastly, the faster pace of adjustment towards price instead of interest rate equilibrium implies the nonappearance of sequencing problem in market integration. Putting together, our model contributes as an early warning system for Malaysia’s economic defense against global shocks.