The Dynamic Relationship between Private Final Consumption Expenditure and Gross Domestic Product: Evidence from Colonial Malaya and Post-independence Malaysia.

AuthorHong, Tan Juat

Using a panel cointegration approach, this study examines the relationship between aggregate consumption and GDP in colonial Malaya (1900-39) and post-independence Malaysia (1970-2009). The findings suggest that private consumption and GDP are cointegrated across the two forty-year periods, indicating a stable relationship in the long run. This is significant as the two periods are completely bipolar in terms of economic structure, stage of development and economic management. The vector error-correction models reveal that adjustment to long-run equilibrium is achieved through changes in both consumption and GDP, though the response of GDP to disequilibrium is stronger. Cointegration regressions of DOLS and FMOLS are used to estimate the marginal propensity to consume (MPC) between the two periods.

Keywords: Aggregate consumption, GDP, panel cointegration, error-correction method, colonial Malaya, post-independence Malaysia.

Article received: November 2017; revised: July 2018; accepted: October 2018

  1. Introduction

    This paper investigates the behavioural relationship between Private Final Consumption Expenditure (PFCE) and Gross Domestic Product (GDP) in two entirely different political and economic systems: British colonial Malaya (1900-39) and post-independence Malaysia (1970-2009). During the colonial phase, the authorities adopted a laissez-faire economic system which was dominated by the British private sector. This resulted in highly uneven development, with economic growth and prosperity mainly benefitting the colonialists. After independence, with national control over economic management, pro-poor affirmative policies aimed at supporting a more unified and socially just nation have been put in place.

    The study estimates the short- and long-run Granger-causal relationships between PFCE and GDP using panel time series data. It aims to provide empirical evidence regarding the sustainability of aggregate domestic private consumption and its impact on economic growth and well-being. Moreover, studying the relationship between PFCE and GDP helps us to better understand the dynamic causal linkages between these two variables in support of macroeconomic policy decision-making.

    Aggregate consumption expenditure plays a key role in Keynesian economics. An increase in autonomous components of spending--such as private and government consumption--will have a multiplier effect on aggregate demand when consumption is closely linked to national income. High levels of consumption may not be sustainable if they imply high levels of personal sector debt (Kim, Setterfield and Yuan Mei 2014).

    With the recent availability of historical national income accounts for Malaya (1900-39), it is now possible to conduct research on the effectiveness of domestic aggregate consumption expenditure and its relationship with economic growth during the British colonial era and after independence in 1957.' This study is organized as follows. The next section provides a brief account of the Malayan economy. The third section includes a brief literature review. The econometric technique and panel data series employed are described in the fourth section. The final section discusses the results of the analysis and policy implications.

  2. The Malayan Economy Before and After Independence

    Colonial Malaya's economy in the early twentieth century was heavily dependent on international trade, foreign capital and foreign skilled labour for its growth and development. Trade and exports were focused on primary commodities, predominantly rubber and tin, and subject to much volatility on account of changes in demand from its main trading partners, the United States and the United Kingdom. As a small and open economy, Malaya experienced "roller-coaster" growth--fluctuating sharply from year-to-year based on the performance of its tin and rubber exports. Economic growth and development were highly inequitable and geographically unbalanced (Sultan Nazrin Shah 2017). Uneven development resulted because colonial investments were concentrated in areas where natural resources could be most readily exploited, and in economic activities that supported these industries (Huillery 2009; Ricart-Huguet 2017). The British colonialists established a conducive enabling environment for the private sector to attract foreign capital and foreign labour (Lim 1977). This included investments in physical and social infrastructure, such as urban transportation and health systems. With the greater integration of the Malay states, standardized laws, administration policies and regulations were progressively implemented (Butcher 1979).

    From being an economy dominated by activities like extraction and production of natural resources, post-independence Malaysia endeavoured to diversify, first within agriculture to oil palm, and later to manufacturing and services, as well as exploring its hydrocarbon resources. With a massive shift of labour away from employment in agriculture to the modern urban sectors, the country experienced rapid structural transformation from the 1970s onwards (Timmer 2017). Malaysia moved through a path of import substitution, heavy industrialization, manufacturing and value-added service activities, with increasing emphasis on human resource development. Today, the ultimate goal is to achieve high standards of living and prosperity, on par with high-income, developed economies.

    Figures 1a and 1b provide a comparison of trends in GDP and consumption per capita for colonial Malaya (1900-39) and post-independence Malaysia (1970-2009). The annual growth rates for real GDP and consumption per capita were 2.9 per cent and 1 per cent respectively for colonial Malaya. The corresponding annual growth rates were higher, at 3.7 per cent and 3.5 per cent for post-independence Malaysia. Growth in GDP, and especially for consumption, improved considerably whilst the country was under national economic management.

    Based on the two forty-year time series trends, the wedge between GDP and PFCE per capita appears to be much greater for colonial Malaya (Figure la), as compared to post-independence Malaysia (Figure 1 b). This marked disparity reflects the much higher levels of remittances of profits and wages being repatriated during the colonial period, which were leakages from the economy. During the post-independence era, the differential was smaller, primarily due to improved economic management aimed at reducing high levels of poverty and bringing about more equitable development. Measures included: the establishment of financial institutions and credit facilities; the availability of financial intermediaries; more efficient logistics and transportation; as well as much improved labour wages. All of these factors helped to enhance household borrowing and consumption spending, in tandem with a higher standard of living.

    The co-movement of GDP and PFCE per capita trends for both periods is transitive to national exponential economic growth. GDP and consumption are positively related. However, their relationship for both short- and long-run periods remains an empirical question.

    Figure 2 shows the ratio of PFCE to GDP during both periods. The mean ratio of PFCE to GDP was 0.63, or 63 per cent of Malaya's GDP. The average propensity to consume (APC) remained volatile and drifted with much gyrations. The APC reached its nadir at 44.7 per cent in 1925, and its peak at 75.8 per cent in 1932--a range of 31.1 per cent. Private aggregate consumption expenditure patterns were highly volatile during this era. For post-independence Malaysia, the corresponding trend shows the mean ratio of PFCE to GDP at 0.51, or 51 per cent--lower than the colonial era. The APC reached its lowest point at 41.6 per cent in 1999 and its zenith in 1972 at 60.6 per cent. In other words, the APC falls as time progresses, while consumption patterns remain volatile.

    During bom phases, the ratio of PFCE to GDP was relatively high compared to the other components of GDP. In general, the contribution of PFCE to real GDP growth was most evident during the early 1900s, and then again throughout the post-independence period, particularly in the 1990s when the economy was booming (Figure 3a and 3b). The gap between GDP and consumption growth, which was higher in the colonial than in the post-colonial period, can be explained by the fact that GDP growth in colonial Malaya was driven more substantially by large trade balance surpluses than in post-independence Malaysia.

    In some years, mainly during the early 1900s, growth in gross fixed capital formation also contributed a larger share to GDP growtii as compared to the growth in PFCE. Post-independence, particularly in the 1990s and before the Asian Financial Crisis, real GDP growtii was also propelled by an increase in investment. Malaysia's GFCF ratio was one of the highest in the region, peaking at over 40 per cent of GDP. However, since the 1997 Crisis, the investment ratio has never returned to its peak. Since 2000, with the trade surplus narrowing, PFCE growth has taken over as the largest contributing component to GDP growth. However, with the current account in surplus, there is evidence of underinvestment and excess savings. Meanwhile, on average, the direct contribution of government consumption to economic growth was negligible during the colonial period, and relatively small post-independence.

    The World Bank's key development indicators on household final consumption provide a basis for cross-country comparison of household final...

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