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Malaysian government conducts the nations monetary policy by changing interest rates and adjusting the quantity of money. The central bank of Malaysia, Bank Negara Malaysia uses interest rate targeting for the time being. By using monetary policy, BNM can increase or decrease money supply as well as the interest rate. BNM will set monetary policy base on different economy situation whether inflation or recession, by increase or decrease the interest rate in order to achieve macroeconomic objectives. Subsequently, monetary policy will influence aggregate demand of the country in terms of three components, which are consumption, investment and net exports. Monetary policy instrument that normally used by BNM is the interest rate at which the banks make overnight policy rate (OPR). Malaysian government can set the open market operation and statutory reserve ratio to control the monetary policy. Besides changing the interest rates, BNM will be imposing open market instrument to reduce or adding money supply in the market by selling or buying securities. Moreover, statutory reserve ratio is an instrument to reserve the money supply.

Here are some examples of how Malaysian government set monetary policy to fight recession and inflation. In a recession, real GDP is lower than potential GDP. This lead to high unemployment due to some firms operating below normal capacity. To reach its goal of high employment and overcome recession, the government needs to carry out an expansionary monetary policy by increasing the money supply and decreasing interest rates. Lower interest rates cause an increase in consumption, investment and net exports, which increase the aggregate demand. Besides that, the government will also reducing bank’s reserve requirement and also purchasing government bonds. At the end, real GDP increase to the potential GDP and the price level rises then recessionary gap will be eliminated.

For example, during financial crisis on 1998, credit flow in Malaysia is slow. Therefore, Bank Negara Malaysia had take action in increasing liquidity in banking system and then increase the credit. In year 1998, government decreased the statutory reserve requirements from 13.5% to 10% (February), 8% (July) and 4% (October).

However, in inflation, real GDP is higher than potential GDP. Therefore, BNM will use a contractionary monetary policy to keep aggregate demand from expanding so rapidly that the inflation rate begins to increase. BNM will impose an action to lower the inflation rate and restore the price stability which by increasing the OPR. BNM will increase the target OPR and sells securities and decrease the supply of reserves of the banking system, the banks reduce deposits by decreasing loans and reduce the supply of money. The short term interest rate increase and reduce the quantity of money demanded. Then, banks decrease the supply of loans decreases the supply of loanable funds and the supply curve shift to the left. The decreasing in investment will lead decreasing in aggregate planned expenditure. The aggregate demand will be decrease therefore real GDP fall to the potential GDP and the price level falls then inflationary gap will be eliminated.

Fiscal policy

Fiscal policy refers to the use of the government budget to influence economic activity. Malaysian government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services in order to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability. The two main instruments of fiscal policy use by Malaysian government are government taxation (revenue collection) and expenditure (spending). There are three possible stances of discretionary fiscal policy, namely neutral, expansionary and contractionary. However, how the Malaysia government set fiscal policy? The policy response is depend on the economic situation, either it occur a recessionary gap, inflationary gap, budget deficit or surplus. For instances, expansionary fiscal policy will be use during recessions, which is tax cuts and increased government spending in order to increase demand and economics growth while contractionary policy will be use during booms, which is increased taxation and lower government spending to reduce demand and reduce inflation.

Here are some examples of how the Malaysian government has set fiscal policy. In a recession, the government may decide to increase borrowing and spend more on infrastructure spending. The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effect, where the initial injection into the economy causes a further round of higher spending. This increase in aggregate demand can help the economy to get out of recession.

For example, in year 1997 and 1998, the Malaysian economy had faced with a sharp global recession. Therefore, Malaysian government had set an expansionary fiscal policy in year 1998 to overcome the recession. The fiscal measures included a selective increase in infrastructure spending, introduction of tax incentives to support private and domestic sector, such as tourism and small and medium enterprises (SMEs), a higher allocation for social sector development and a reduction in taxes. Government has increasing the development expenditure of RM7 billion into agriculture, education and housing area development; and a RM 5 billion in the infrastructure projects. (Ministry of Finance 2001, Bank Negara 2002)

In addition, government can also implement the tax cut policy in order to overcome recession. Tax cut in service tax, sales tax, excise tax, export duties, import duties, income tax or an increase in transfer payments, for example, unemployment benefits or welfare payments will increase disposal income, therefore increase the purchasing power of households. Reducing in the corporation tax will also raise the ability in the investment. Hence, aggregate demand will increase and this will close the recessionary gap therefore increase economic growth and reduce unemployment.

Other than that, expansionary fiscal policy also helps to reduce budget deficit. For example, in order to reduce the budget deficit in 2012, which is 4.7% at GDP, a prudent fiscal policy was implemented by Malaysian government. It is aim to promote domestic economic activity and providing support to the economic transformation plan. In order to achieve the objectives of full employment and sustained economic growth, government had emphasis on the growth of private sector investment and consumption in the 2012 Budget. Hence, these will increase the aggregate demand by increase the government expenditure on goods and services on spy satellites, school, highways and the list goes on.

Furthermore, as a part of the Government’s efforts to increase aggregate demand, a large amount of fund was allocated for various forms of incentives and subsidies in order to support the private consumption. For instance, some financial Helpance programmes had been introduced such as the cash Helpance of RM500 to households with monthly income of less than RM3, 000 as well as the SARA 1Malaysia scheme, RM100 schooling subsidy to all primary and secondary students and the book voucher worth RM200 to all Malaysian students in Form 6 and institutions of tertiary education. Households also continue to have access to credit markets, especially for the purchase of durable assets, supported by more sustainable ¬nancing and accommodative monetary conditions. Besides that, government had also announced several policy measures to stimulate home ownership for the middle-income group, including the 1Malaysia People’s Housing Scheme (PRIMA). The Government will continue to ¬nance the budget de¬cit from domestic sources, mainly through the issuances of Malaysian Government Securities (MGS) and Government Investment Issues (GII), given the high domestic savings and the ample liquidity in the ¬nancial system.