Is inflation targeting the proper monetary policy regime in a dual banking system? new evidence from ARDL bounds test

This paper explores the appropriateness and consequently the feasibility of inflation targeting in an economy with a dual financial system. We take the case of Malaysia, an example of a successful coexistence of the conventional and Islamic systems. The study employs ARDL bounds testing approach to investigate the long run relationship between inflation rate, real effective exchange rate, statutory reserve rate, narrow money, Islamic interbank rate and the overnight policy of Malaysia, considering the major transmission mechanism channels in the conduct of monetary policy stance. An Error Correction Model (ECM) is used to capture the short run dynamics, and variance decomposition of forecast errors is used to determine the causality direction of the variables. The periods considered was monthly data from the June 2007 to February 2017. Our results show that there is a long and short term relationship between inflation, narrow money, statutory reserve rate, real effective exchange rate and the Islamic interbank rate. However, we suggest that Inflation targeting may not be ideal in a dual banking system, especially the case of Malaysia. Alternatively, interest rate targeting is found to be most effective. Additionally, it will give the central bank more control over the Islamic segment of the financial system.