Determinants of Inflation Rate: the Case of Malaysia

Chan, Wen Xuan (2026) Determinants of Inflation Rate: the Case of Malaysia. Final Year Project (Bachelor), Tunku Abdul Rahman University of Management and Technology.

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Abstract

This study examines the impact of monetary policy instruments on inflation in Malaysia by focusing on the roles of interest rate, money supply, and exchange rate. Inflation remains an important macroeconomic issue because persistent increases in prices reduce purchasing power, increase business uncertainty, and may weaken overall economic stability. In Malaysia, Bank Negara Malaysia uses several monetary policy tools, particularly the Overnight Policy Rate (OPR), liquidity management, and exchange rate stabilisation measures, to maintain price stability. Therefore, this study investigates whether these policy variables significantly influence inflation, as measured by the Consumer Price Index (CPI). The study employs monthly time series data covering the period from 2019 to 2024. The variables included are CPI as the dependent variable, while money supply (M3), exchange rate (RM/USD), and interest rate (OPR) are used as explanatory variables. To analyse the relationships among variables, several econometric techniques are applied. Unit root tests, namely Augmented Dickey-Fuller (ADF), Phillips-Perron (PP), and KPSS tests, are conducted to determine the stationarity properties of the data. Since the variables are found to be integrated at a mixture of I(0) and I(1), the Autoregressive Distributed Lag (ARDL) model is selected as the most appropriate estimation technique. The ARDL Bounds Test confirms the existence of a long-run cointegration relationship among the variables. The empirical findings show that the interest rate has a statistically significant negative effect on inflation in both the long run and short run, indicating that higher policy rates help reduce inflationary pressure in Malaysia. Money supply is found to have a significant positive long-run relationship with inflation, suggesting that excessive liquidity growth contributes to rising prices over time, although its short-run effect is relatively weak. The exchange rate also plays an important role, where depreciation of the Malaysian Ringgit tends to increase inflation through higher import costs, while appreciation helps moderate price pressures. In addition, the error correction term is negative and statistically significant, confirming that short-run disequilibrium adjusts back toward long-run equilibrium over time. Several diagnostic and stability tests, including Jarque-Bera normality, serial correlation LM, heteroskedasticity, ARCH, CUSUM, CUSUMSQ, and VIF tests, indicate that the estimated model is generally reliable, stable, and free from major econometric problems. Overall, the study concludes that monetary policy instruments are important determinants of inflation in Malaysia. The findings imply that maintaining price stability requires a balanced and coordinated policy approach involving interest rate management, liquidity control, and exchange rate stability to support sustainable economic growth in Malaysia.