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Exchange Rate (ER) is the price of one currency in relation to another. It expresses the national currency’s quotation in respect to foreign ones (Azid et al., 2005). Compared to nominal, Real Exchange Rate (RER) is often acknowledged as an important macroeconomic policy variable in the sense that it indicates a country’s international competitiveness. The RER is the Nominal Exchange Rate (NER) adjusted for price changes (inflation) in the domestic relative to those of trading partners. The NER management depends on the RER, and the RER is influenced, among others, by NER (Montiel, 1997; and Thapa, 2002). This is due to the close correlation between real and nominal exchange rates where NER often drives the RER. In addition, usually changes in RER tend to be highly persistent or permanent.
A stable long-term economic growth requires stable trade and foreign exchange markets to ensure a stable ER system and favorable terms of trade in addition to appropriate basic physical capital stock. However, often (real) ER misalignment affects economic growth. In developing countries, ER misalignment has often taken the form of overvaluation which adversely affects the tradable goods by lowering producers’ real prices. The RER misalignment, for instance, occurs in markets in which actual ERs are not allowed to adjust to changes in economic fundamentals (Thapa, 2002), consequently reducing the incentives and profits, leading to decline in investment and export volumes.
In addition, economic growth in developing countries such as Malaysia was (most often) influenced jointly by external environment, ER mismanagement and domestic factors such as population growth in the long run. The objective of this study is to examine the effect of the ER as one of the monetary policy tools on economic growth by considering it in both nominal and real term, and at the same time, to look for the causal pattern between both ERs and economic growth in Malaysia using annual data over the period 1971-2009. Do these ERs give similar effects to economic growth? Is the real surpassing the nominal in terms of its role as a monetary policy tool? Certainly these questions need further investigation.
The study is organized as follows: it presents a brief highlight of the literature review, followed by a description of the data and methodology used in the study. Subsequently, it presents the empirical results, and finally, offers a discussion and some concluding remarks.
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