Financial Development and the Effectiveness of Monetary Policy: New Evidence from Malaysia

Abstract

This paper examines the relationship between financial development (FD) and the monetary policy effectiveness (MPE) in Malaysia. Two indicators designate the level of FD, namely liquid liabilities and stock market capitalisation, and gross fixed capital formation are used in estimating the determinants of MPE which is generated using structural vector auto regressive (SVAR) in an open economy approach. Accordingly, an autoregressive distributed lag (ARDL) model is used in examining the effects of FD and gross fixed capital formation on MPE. Using a yearly time series data spanning from 1991 to 2016, the results revealed that there is a cointegration between FD and gross fixed capital formation on MPE. Interestingly, FD has a negatively significant effect on MPE on output and inflation, which indicates that a more developed financial system has hindered the effectiveness of the monetary policy.