Exchange Rate – Relative Price Relationship: Nonlinear Evidence from Malaysia

Using nonlinear unit root tests developed by Kapetanios et al. (2003), we find strong evidence that the Consumer Price Index (CPI) and Wholesale Price Index (WPI) based Malaysian Ringgit – U.S. Dollar (MYR/USD) real exchange rates are nonlinear stationary, implying that MYR/USD nominal exchange rate and relative price are cointegrated regardless of price indices. The results in this study are supportive of Purchasing Power Parity (PPP) and are more robust than previous study, which did not take the nonlinear exchange rate adjustment behavior into consideration. Few principle implications may be drawn from this study. First, nonlinear PPP equilibrium may be regarded as reference point in judging the short run misalignment of the Ringgit currency and thereby deducing effective policy actions. Second, the effort of Bank Negara Malaysia (BNM) in managing the Ringgit in certain fluctuation bands has successfully maintained Malaysian’s macroeconomics equilibrium in the sample period of study. Third, economists who wish to extend the simple PPP exchange rate model into the more complicated monetary exchange models may do so comfortably, at least in the text of Malaysia. Nonetheless, such attempt should be tailored in a nonlinear way to suit the nonlinear characteristic of exchange rate behaviour.