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The importance of external sector to Malaysian economy means that changes in the terms of trade is one of the main sources of macroeconomic instability to the country. Utilizing the 1-2-3 Computable General Equilibrium (CGE) model, this study examines the impact of terms of trade shocks on Malaysian economy. This study shows that even though Malaysia is industrializing, its terms of trade is subject to deterioration. Simulations for the model shows that terms of trade deterioration affects key macroeconomic variables negatively, reducing welfare. To lessen the negative impact of terms of trade shock in the short run, the study proposes a reduction in indirect tax instead of subsidy. In the long run, Malaysia needs to diversify its exports and shifts into technological intensive product. In addition, there should be strong linkage between domestic-oriented sector and export-oriented industries to improve the value added of the exports.