Monetary neutrality: why we can’t escape the hit to real incomes If you open an A-level economics textbook one of the first things you’ll see is something like Chart 4. The “AS” (aggregate supply) lines trace out the response of output and prices to a change in aggregate demand (represented by a shift in the “AD” line), for example from a change in the stance of monetary policy. Bank of England  Page 8  Chart 4: Monetary policy only affects real variables for a while  In the short run the supply curve is upward sloping (“SRAS”), so stronger demand can raise output as well as prices. This is more or less the relationship that A.W. Phillips had uncovered, using pre-WWI British data, in his 1958 paper2. But students are also taught that, over time, once prices adjust in full, there is no effect of monetary expansions on real output. The long-run Phillips curve – here labelled an aggregate supply (“LRAS”) relationship – is vertical. The idea that money is “neutral” – that it has no enduring impact on real output or incomes – goes all the way back to David Hume, in the mid-18th century. It also makes intuitive sense, I think. Most people would instinctively understand that one cannot permanently enrich a country simply by dolling out more banknotes. In the end, all that would do is to raise all prices and wages equiproportionately and nothing real would be affected.
While Malaysia will always be affected by such external developments, the strategy has been to have the flexibility to absorb and adjust and the strength to rapidly rebound. While each crisis or setback has been different, there are several common features that have allowed Malaysia to rapidly recover from such shocks. For each respective major shock confronting our economy, Malaysia has registered V-shaped recoveries. This has essentially reflected the flexibility of the economy to adjust and the early and comprehensive policy response. The ensuing periods were often marked by structural reforms and institutional development that were designed to rebuild the fundamentals of the economy, address the weaknesses and vulnerabilities and to forge new areas of growth. This has, decade after decade, resulted in vital changes in our economic structure, from being export-led to now being predominantly domestic demand-driven, and from being over-reliant on specific sectors to having a more diversified economic structure with the manufacturing and services sectors having now transitioned to higher value added activities. In essence, the structure of the economy has now become significantly more diversified in terms of sources of growth. While the export sector remains an integral component of our economy, domestic demand has now become the key driver of growth, anchored by strong private sector activity that now accounts for 70% of GDP. Underpinning the robust domestic demand is the sustained consumption spending and the revival of investment activity by the private sector.