Granger Causality Analysis between Inflation, Debt and Exchange Rate: Evidence from Malaysia

Sweeping inflation across the globe and historical high domestic inflation that reached two digits in Malaysia in 1974. Also, warning from Wall Street Journal of growing domestic debt and newly defined external debt starting year 2014 call forth this paper to examine the dynamic relationship between inflation, external debt, domestic debt and exchange rate for Malaysia covering the period of 1960-2014. This article used exploratory data analysis, Johansen cointegration test, and Granger causality test. The exploratory data analysis show that domestic debt and external debt have a strong positive association with inflation, meanwhile a weak positive association between exchange rate and inflation. The cointegration test indicates that there is one long run relationship. In Malaysia, inflation found to granger caused domestic debt, exchange rate granger caused inflation, and domestic debt granger caused exchange rate. A unidirectional relationship found for external debt and exchange rate. In short run, external debt is influencing inflation significantly. Observing the heightening level of external debt by IMF redefinition, external debt caused exchange rate will then lead to inflation. In the long run, the exchange rate is influencing inflation significantly. Hence, policy makers need to formulate appropriate and prudent policy, especially in the high inflation period as the impact of exchange rate during inflation period will be stronger.