International Journal of Business and Economy

e-ISSN: 2682-8359 | Vol. 2, No. 4, 104-114, 2020

http://myjms.mohe.gov.my/index.php/ijbec

International Journal of Business and Economy (IJBEC)

eISSN: 2682-8359 [Vol. 2 No. 4 December 2020]
Journal website: http://myjms.mohe.gov.my/index.php/ijbec

THE EFFECTIVENESS OF THE MONETARY

TRANSMISSION CHANNEL ON AGGREGATE DEMAND
DURING THE HEALTH PANDEMIC

Caroline Geetha1*
1
Faculty of Business, Economics and Accountancy, Universiti Malaysia Sabah, Kota Kinabalu, MALAYSIA

*Corresponding author: caroline@ ums.edu.my

Abstract: The study aims to identify whether the monetary

Article Information:
transmission channel theory introduced by Keynesian. The
study uses a simple review method to review whether the
expansionary monetary policy carried out by Bank Negara
Article history: Malaysia would be able to fulfil the government’s objective
Received date : 3 November 2020
to maintain price stability, increase output and also
Revised date : 15 November 2020 employment. The action taken by Bank Negara Malaysia is
Accepted date : 25 November 2020 to reduce the interest rate and to provide moratorium for
Published date : 4 December 2020 6 months.to the citizen of Malaysia. The underlying theory
which is the monetary transmission channels. The review
To cite this document:
was made using the money channel, the credit view which
was distinguished into bank lending channel and balance
Geetha, C. (2020). THE sheet channel, the interest rate channel and the exchange
EFFECTIVENESS OF THE rate channel. All the channels clearly state the aggregate
MONETARY TRANSMISSION
CHANNEL ON AGGREGATE
demand will not increase but decrease leading to a fall in
DEMAND DURING THE HEALTH the general price level as well as a fall in the output
PANDEMIC. International Journal Of produced and employment. The objective of the Malaysian
Business And Economy, 2(4), 104-114. government together with the monetary policy will not be
achieved using monetary policy actions carried out by
Bank Negara Malaysia.

Keyword: monetary policy, monetary transmission

channel, health pandemic.

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1. Introduction
Monetary policy is a tool used by the country to stabilize the economy. Monetary policy stabilizes
the economy using money supply. When the money demand is equal to money supply, the
economy is stable. Discrepancy between money demand and money supply creates shocks in the
economy. These shocks can change the nominal variables as well as the real variables in the
economy. Monetary policy players are the central bank and other financial intermediaries. The
monetary policy players use three basic tools to control money supply, the open market operation,
discount rate and reserve requirement with the objective to create full employment as well as
stability in price together with maintaining long term interest rate. These tools are known as
quantitative monetary tools. The monetary policy also practices qualitative monetary policy tools,
like rationing of credit and moral suasion. Rationing of credit controls the credit granted or
allocated by the commercial banks meanwhile moral suasion is a psychological means or credit
means of selective credit controls.

There are two types of monetary policy, contractionary monetary policy and expansionary
monetary policy. Contractionary monetary policy is a policy that contracts money supply. It
decreases the amount circulating in the economy. This is carried out by selling government bonds
and treasury bills, raising the discount rate and the rate of reserve requirement. As for the
qualitative method, measures will be taken to ration credit by restricting the amount of credit
allocated as loan also use selective credit controls in distributing credit. In contrast an expansionary
monetary policy aims to increase money supply circulating in the economy by buying government
bonds and treasury bills, decreasing the discount rates and the reserve requirement rates. Credit
rationing as well as moral suasion is relaxed.

When either contractionary monetary policy or expansionary monetary policy are practiced, the
monetary transmission mechanism will take place. The monetary transmission mechanism is a
process by which the asset price or the economic condition are affected as a result of the monetary
policy decision. Such decision will eventually influence the domestic economy as well as the
international economy of the nation. In the domestic economy, aggregate demand will change. A
contractionary monetary policy that decreases money supply will decrease aggregate demand, in
contrast an expansionary monetary policy increases money supply and eventually increases the
aggregate demand. An increase or decrease in aggregate demand can influence the output and price
level of the nation. Changes in output or productivity is known as changes in real variable. When
price level changes nominal value also changes. When price increases, nominal value for
macroeconomic variables like interest and wage will increase but the real value decreases. This
influences the supply of labour and investment in the nation. Thus, it can be concluded that changes
in the nominal variables will influence the real variables in the domestic economy. Similarly
changes in the price level also influences the interest rate and the demand for exports. Thus,
demand for investment in the domestic economy by foreign investors and demand for export by
foreign traders or consumers will change the demand for domestic currency. This eventually
influences the exchange rate of the nation creating an impact in the international economy.

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1.1 Problem Statement

As at April, 2020, Malaysia has reported 4348 cases and a recovery of 1830 cases. Malaysia was
ranked 34 among the 213 countries affected by the virus. One major reason that lead to the recovery
of the sickness is due to the climate in Malaysia which has a temperature of 40 degree Celsius.
This climate enables us to control the spread of the disease because the virus was not able to survive
in high temperature. In Malaysia the massive and ongoing outbreak of the virus has cased a
profound impact to the economy and also the financial market in Malaysia. The number of cases
began to increase significantly until the government decided to implement financial market is in a
verge of collapse. The movement control order (MCO) was implemented to control the spread of
the virus. Unfortunately, it brought many sectors into jeopardy. Many workers in the agriculture,
tourism, manufacturing, entertainment, service industry was either laid off, receive a pay cut or
even force to take unpaid leave. This leads to the closure of many small and medium scale
business. Many were not able to sustain themselves. This leads to bankruptcy. Since many lost
their source of income, the government decided to ease the monetary policy by implementing
expansionary monetary policy. In this expansionary monetary policy, the government gave a
moratorium for six months for those who borrowed money from banks. The moratorium began in
April and lasted until September, 2020. The bank rate was also reduced as much as 25 points to
encourage borrowing. The aim of the government was to boost the domestic economy. When
domestic economy grows, aggregate demand will increase. Output or GDP will increase. Since the
inflation rate was still low, thus the expansionary monetary policy was found to be appropriate to
boost domestic demand without worrying on disruption in price stability.

Malaysia was one of the first few countries who came up with quick responses to protect its citizen
by minimizing social and economic adverse impact of the pandemic. The ease in the monetary
policy helps to maintain price stability and at the same time increase productivity and create
employment. Question arises whether the quick and the fast move made by the government fulfils
its objective or further pushed the profound social and economic condition to a more dangerous
situation in the long run or was it just a short term solution to an ongoing pandemic.

1.2 Objective
The aim of this paper was to evaluate whether the expansionary monetary policy implemented by
the Malaysian government was able to fulfil its objective in stimulating domestic demand and ease
the financial burden of the citizen.

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2. Literature Review
2.1 Monetary Transmission Channel When Expansionary Monetary Policy Is Implemented
Monetary transmission channel is a process in which the asset prices and the economic condition
faces changes due to the changes in the monetary policy. The traditional monetary transmission
process works through many channels like the money view, the credit view (bank lending channel
and balance sheet channel), interest rate channel and the exchange rate channel.

Money View. According to money view, when expansionary monetary policy was implemented,
money supply increases because the central bank will buy bonds and treasury bills, reduce the
reserve requirement ratio and the discount rate. Thus, the deposits in the financial institution that
can be distributed in the form of loan will increase. This increases money creation. Money creation
increases the purchasing power. This increases the aggregate demand for goods and services in the
economy. When aggregate demand increases, output will not increase in the short run because
aggregate supply is vertical in the short run. Aggregate supply cannot be increase in the short run.
Thus, this creates excess demand. Excess demand will increase the price level but not output.
Increase in price will decrease the real value of money and the real wage. A decline in real wage
rate will reduce the supply of labour. Only in the long run aggregate supply can be increased due
to increase in resources available. Therefore, when aggregate demand increases, both price and
output will increase in the long run. In addition, the Keynesian also incorporates the rational
expectation theory where all macroeconomic variables can be differentiated as anticipated and
unanticipated. Anticipated changes in money supply will not have an impact on output and
employment but unanticipated changes in money supply does have an impact on both output and
employment. Thus, Keynesian claims anticipated changes in money supply makes money neutral
in the short run and long run but unanticipated changes in money supply makes money non-neutral
in the short run but in the long run discrepancy in money supply with money demand stabilizes
and money becomes neutral.
Credit View. Credit view turns money into credit when deposits are accumulated and disbursed
as loans. When loans are disbursed, credit worthiness of a firm or individual is assed. The
individual or the firm provides their financial statements, like income statement and balance sheet.
If the net worth of the individual or the firm is low, the financial system requires them to pay
higher interest called external financial premium to overcome risk of default in payment. The
higher interest rate will increase the cost of borrowing. This declines the amount of loan or
investment. This eventually decreases the aggregate demand. This is known as bank lending
channel in credit view. In addition, increase in interest rate will increase expenses stated in income
statement. The net income earned will decline. A decline in net income will reduce the retained
income in owner’s equity at the balance sheet. Similarly, an increase in interest will reduce the real
value of assets in the balance sheet. An increase in interest rate increases the mortgage for bank
and also notes payable. This increases liability in the balance sheet. The increase in interest will
increase the demand for bond and reduces the demand for equity, which affects the value of
owner’s equity at balance sheet. Overall, it can be concluded increase in interest rate decreases the

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value of assets, reduces owner’s equity and increases liability. This eventually decreases the net
worth of a firm. This is known as the balance sheet channel.
Interest rate channel. When expansionary monetary policy takes place, money supply increases.
Excess supply of money decreases the interest rate. A fall in interest rate can increase the demand
for investment. Since investment is a component in aggregate demand, increase in investment will
increase in aggregate demand.

Exchange rate channel. When expansionary monetary policy takes place, money supply
increases. Excess in money supply will decrease the interest rate. Decrease in interest rate will
decline the investment by foreigners in the domestic economy. This eventually reduces the demand
for Ringgit Malaysia. This decreases the exchange rate of Ringgit Malaysia. It reduces the cash
flow into the nation. When exchange rate declines, export is cheap but import is expensive.
Demand for local goods and serviced can increase. Thus, aggregate demand can increase.

2.2 The Effectiveness of Monetary Transmission Channel in Developing Economics

Ufuk Can, Mehmet Emin Bocuoglu nd Zeynap Gizem Can (2020) claims the effectiveness of
targeting inflation differs based on the monetary transmission channel used by the central bank of
the nation. Turkey, an emerging economy used the interest rate channel where the federal fund
rate was changed. The federal fund rate changes influence the output in Turkey. The fluctuation in
the output measured using the vector auto regression method was due to changes in asset pricing
and liquidity. Disyatat and Vongsinsirikul (2003) supports that interest rate channel as a great
impact on price but it only has a transitory effect on output. Since the economy of Thailand is
highly integrated economy thus the exchange rate also has an impact to the economy of Thailand.
Similarly, in a small and emerging economy like Sri Lanka, the monetary transmission channel
worked effectively in credit channel, exchange rate channel and also the interest rate channel. It
had a great influence on the asset price and income.

Study by Kamin, Turner and Van ‘t dack (1998) calaim that understanding and implementing the
transmission process is important in designing and implementing the monetary policy. This is
because it can influence the balance sheet position, the financial system deepening process and the
expectation of the future policy. In recent years it has been argued that monetary policy in any
nation should focus on price stability only and not on output or employment. How should we
decide the appropriate number for inflation rate, 2 % and 3%. These figures are usually discussed
in industrialized nation other than zero. But there is problem in statistical measurement and relative
price of adjustment varies in different sectors. The inflation rate is relatively positive and small in
a industrialized nation.

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But the inflation targeting in a developing country is much higher. This is because of the political
instability that takes place in these countries. Political pressure for the central banks to practice
expansionary monetary policy makes it difficult to fulfil to monetary policy goals. When a
developing country is dependent on international trade, changes in the external factors will
influence the exchange rate channel and the money channel through money supply. The financial
strength should be strong enough to be able to absorb the shocks as soon as possible. If the country
fails in having a sophisticated financial system, then diversification can distort the stabilization
process.

In addition, the more integrated and open an economy i flow and outflow of foreign capital takes
place. This makes a country’s capital account sensitive to these inflows and outflows. Therefore,
it affects the reserve in the official financing of the balance of payment. In a developing nation the
amount of reserve are not enough to sustain deficit in the balance of payment. Thus, the monetary
policy is used to stabilize the balance of payment as well as the exchange rate of the nation.

Abdul Aleem (2010) stresses that effectiveness of the monetary transmission channel depends on
the financial structure and legal of the country. The author claims the effectiveness of monetary
policy in the developing nation and emerging economics depends on the influence of central banks
like the Federal Reserve, European Central Bank and Bank of Japan. The author claims that India
has a bank based economy. Since 2005, bank credit to the commercial sector accounts for more
than 70 percent of the total domestic credit. The ratio of currency deposits has declined since 1999.
Thus, it is proven that bank is an important financial intermediation and non financial institution
lacks alternative sources of funding. The empirical evidence proved that the bank lending channel
plays an important role in transmitting the changes in the money supply impact towards the real
sector. The bank lending channel was also deemed important because the lower market
capitalization by the listed company in India compared to developed country shows that India’
capital market is not fully developed. Asset pricing channel did not really influence the real sector.
Moreover, the Reserve Bank of India always practice unanticipated changes in money supply to
stabilize the exchange rate. This further weakens the exchange rate channel.

Ooi Sang Kuang (2020) states that Malaysia’s financial system can be characterised as full of
banking services, growing capital market and international openness. The total assets of the
financial system is 386 percent of the country’s GDP where more than 50 % of the financial assets
originates from the banking system. This means that banking system is an important financial
intermediary in Malaysia. Since the financial crisis that took place in 1997, there has been a
significant change in the financial system in Malaysia. Before the crisis, the banking system
consists of large number of small companies. After the crisis, in 1998 the banks merged and
consolidated into nine domestic banks. By 2006 the banks were more resilient, effective,
competitive and responsive towards the changes in the economic conditions. The strengthening of
the financial restructuring has improved the balance sheet of the financial institution. Later the
financial institution began to focus in upgrading the operation efficiency for their customers. This
was supported by the internal study conducted by Bank Negara Malaysia. The study revealed that
bank efficiency increased due to declining trend in the net interest margin. The tight interest margin
was found to be associated to bank efficiency in many studies conducted by previous researchers.
This was followed by Bank Negara Malaysia in designing the New Interest Rate Framework in
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2004 which resulted in liberalization at asset pricing. This increased the level of competition in the
financial system. Since the crisis, Malaysian had greater proportion of loans allocated for the
households and businesses can raise capital by the issuance of bond and equity through the banking
system. These progress shows the development of the capital market. This also improved the
availability of funds through private debt securities and equity. The increase in bank competition
and efficiency enables the transmission of the monetary policy to be effective. The pass through
effect of the interest rate channel will not be disrupted. Unfortunately, almost 87 % of SME
financing comes from sources other than the banking system. It comes from the self funding,
informal sectors, government grants and development fund from foreign sources. These funds are
distributed below the market rate to the SME-s. This will cause the effectiveness of the
transmission of monetary policy distracted. Moreover, the Bank Negara Malaysia has numerous
times intervene in the money market to strengthen the exchange rate for Ringgit Malaysia. This
has disrupted the exchange rate channel in the monetary transmission channel.

3. Methodology
There is ambiguity, lack of clarity and consistency in the monetary transmission channel practiced
in many developing or emerging economics. The monetary transmission channel effective in
stabilizing price, output and employment differs based on the economic development, financial
structure, political interference, legal issues in a country. Moreover, there are country that uses
monetary policy to maintain price stability but recent development in the economic condition
requires the countries to look into other objectives like output and employment to be fulfilled. Up
to date with the current Covid 19 health pandemic, the government has taken several measures
involving monetary policy. By systematically reviewing the monetary policy actions taken by the
Malaysian government supported by the underlying theory of the monetary transmission channel
and the empirical evidence of other developing countries and emerging economics a conclusive
evidence can be derived that the policy actions taken by the Malaysian government would fulfil
its objective.

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4. Discussion
As we have all known the objectives of monetary policy is to maintain price stability, increase
output and employment in a nation. Based on the literature review, many countries use monetary
policy to fulfil one objective or both. In developing country and emerging economics, monetary
policy is used as a macroeconomic policy to maintain price stability. It is seldom used to stimulate
growth and employment.

During the health pandemic due to Covid 19, the Malaysian government began its Movement
Control Order on 18 March, 2020 to control the spread of the virus among its citizen. The
Malaysian government had many fiscal stimulus packages to help reduce the burden of its citizen.
The fiscal stimulus package was either in the form of cash hand outs or in kind. This helped to
boost the economy by increasing aggregate demand in the nation. The increase in aggregate
demand will create excess demand. This leads to an increase in price and also output. The
Malaysian government found that the increase in the general price level was still manageable
during the pandemic. Thus, they decided to further boost the economy by using the next
macroeconomic policy, the monetary policy.
The monetary policy aims to control the amount of money supply circulating in the economy. The
monetary supply uses many tools or instruments to control money supply. Since the economic
growth declined during the pandemic, many citizens lost their income because they were either
laid off or forced to take a pay cut. This automatically reduced the amount of deposits in the bank.
Deposits are essential to create money or money supply. At the same time deposits are also
important for the monetary transmission to take place. The effectiveness of the monetary
transmission mechanism will decline as deposits decreases. The theory quantity of money claims
that when money supply decreases, price level will decrease resulting in deflation. The anticipated
money supply will decline. The money does not have an impact on the real variables like output
and employment in the short run and long run. Thus, money is considered neutral. Due to decrease
in purchasing power, citizen can resort to alternative source of funding to sustain their consumer
expenditure and business like authorized money lenders and unauthorized money lenders. This
create unanticipated money supply. Unanticipated money supply creates shocks in the economy in
the short run. This makes money non neutral. Changes in the unanticipated money supply increases
nominal variables like price and also increase the real variables like output and employment. In
the long run, changes in money supply due to unanticipated money supply will be neutral in the
long run.

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When deposits decline, the amount to be created as loan or dispersed as credit declines. With the
implementation of moratorium for loan owners shows that the government intervene by practicing
expansionary monetary policy. With moratorium the loan owners are exempted from paying loans
for 6 months. This reduces money supply. When money supply reduces, money demand will be
greater than money supply. To balance the money market to achieve equilibrium, money demand
should also be decreased by decreasing income. A decline in money supply will shift the aggregate
demand to the left. Thus, price level and output level also declines. Therefore, the objective of the
government to maintain price stability, increase output and employment will not be fulfilled.

In addition, when money supply decreases through the moratorium, money demand will be greater
than money supply. Citizen will be wanting to pay higher interest rate. This increase external
premium finance. External premium finance is the interest paid higher to get loan. Adverse
selection can take place. The cost of doing business increases. The amount demanded for loan
declines due to increase in cost. Investment declines and eventually decreases aggregate demand.
A decline in aggregate demand will not be able to increase output and employment. This is known
as a bank lending channel. As mentioned in the bank lending channel, increase in the cost of
borrowing money. This increases interest expenses. When interest expenses rise, net income
declines. A decline in net income will reduce the retained earnings. This reduces owner’s equity.
Similarly, an increase in interest will stimulate demand for bond but reduces the demand for equity.
This also decreases owner’s equity. The value of assets decreases and the liability increases
through increase in the mortgage for bank and notes payable. Overall, the net worth of the firm
declines. This decreases aggregate demand eventually decreasing output and employment and
declining price level. Both bank lending channel and the balance sheet channel are used to explain
the credit view under the monetary transmission channel.

Moratorium declines the creation of money. A reduction in money supply increase the interest rate
because money supply is less than money demand. An increase in interest rate, will increase the
demand for bond. Demand for bond increases but the demand for equity declines. The
development of the capital market in Malaysia is still below compared to the developed country.
Thus, a decline in the demand for equity decreases the capital market. Malaysia is a developing
nation that depends on the banking system. 70 percent of the financing depends on the banking
structure of the country. The financial system in Malaysia is still bank based like India. An increase
in interest rate declines investment and eventually the aggregate demand. To stimulate the
economy, Bank Negara Malaysia decreased the interest rate as much as 25 points to increase the
demand for loans. Distributing loans is also based on credit worthiness. During the health
pandemic, the credit worthiness of individual and firms have decline. Thus, the amount of loan
distributed will not be like the expected. Even of government reduces interest rate, demand for
loan becomes questionable because losing of jobs, decline in pay, reduction in profit. Thus, adverse
selection might take place posing a threat to the financial system on increase of non performing
loan in the long run. This might not stimulate aggregate demand as expected in the short run but
in the long run the banking system should be more cautious with the non performing loans which
can destroy the financial system. This can decrease output and employment.
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When the government implements the moratorium the money supply declines. Money supply is
less than money demand. The increase in interest rate will invite foreign investors to invest in
Malaysia. Since the health pandemic has become a global pandemic, the inflow for foreign
investment declines. Moreover, a decline in interest rate by Bank Negara will not influence the
confidence level of foreign investors. This creates an adverse effect on the portfolio choices. The
demand for local currency will decline. This further decreases the exchange rate of Malaysian
Ringgit. In addition, the fall in the productivity in each sector has decline export. When export
declines, the demand for Malaysian Ringgit also declines. This decreases the exchange rate. The
pandemic also decreases the inflow of income of Malaysian who are working in foreign country
like Singapore, USA and UK. Many Malaysian were retrenched from their jobs in overseas. Thus,
the demand for Malaysian Ringgit declines. The effectiveness of the monetary transmission
channel is further disrupted by interference by the Malaysian government to stabilize the exchange
rate and to balance the balance of payment.

5. Conclusion
Bank Negara Malaysia decided to implement an expansionary monetary policy to stimulate the
economy. The central bank decreases the bank rate, to stimulate demand loan. This is done to
increase investment and eventually aggregate demand. When aggregate demand increases, excess
demand will increase the price and output. Since the inflation rate in Malaysia is low, the
government decided to increase output by practicing expansionary monetary policy. When the
price level increases, real value of money falls. This distort the nominal variables like wage. When
real wage falls, the supply of labour falls. Unemployment might increase.

Unemployment and pay cuts decrease deposits and the demand for loan. Thus, the citizen of
Malaysia might resort to alternative sources for funding creating a change in unanticipated money
supply. Unanticipated changes in money supply makes money non neutral in the short run. In
addition, the moratorium given for 6 months from April to September, decreases money supply
created. This increases interest rate because money demand is more than money supply. The
increase in interest rate reduces investment and eventually aggregate demand. Excess supply will
fall decrease the general price level and also output. This is supported by the interest rate channel.
A rise in interest is suppose to encourage the inflow of foreign investment. But since it is a global
pandemic uncertainty is very high, thus the demand for foreign investment declines. This further
reduces the portfolio demand and currency inflow into the country. The exchange rate will
decrease. This has decreased investment and the demand for export thus declining the aggregate
demand. A fall in aggregate demand declines the general price level as well as output.

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A rise in interest rate increases interest expenses, thus reducing retained income, decreases the
value of assets and increases liability. This reduces the net worth of firm. This is explain using the
bank lending and balance sheet channel under credit view. This reduces aggregate demand.
General price level declines and output also declines. Thus, it can be concluded that the monetary
policy might not increase the nominal values like price and real variables like output and
employment. The monetary transmission channel might not be able to influence the aggregate
demand as expected by the country leaders.

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Steven Kamin, Philip Turner & Jozef Van’t dack. (1998). The transmission of monetary policy in
emerging market economies, BIS Policy Papers No. 3, Bank for International Settlements,
Monetary and Economic Department, Basle.
Ooi Sang Kuang (2020). The monetary transmission mechanism in Malaysia: Current
Development and Issues, BIS Papers 35.
Piti Disyatat & Pinnarat Vongsinsirikul. (2003). Monetary Policy and transmission mechanism in
Thailand, Journal of Asian Economics, 14(3): 389-418.
Ufuk Can, Mehmet Emin Bocuoglu & Zeynep Gizem Can. (2020). How does the monetary
transmission mechanism work? Evidence from Turkey, Borsa Istanbul Review.

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