The Effectiveness of Monetary Policy in South Africa under Inflation Targeting: Evidence from a Time-Varying Factor-Augmented Vector Autoregressive Model

By Aye, Goodness C.; Balcilar, Mehmet et al. | The Journal of Developing Areas, Fall 2020 | Go to article overview

The Effectiveness of Monetary Policy in South Africa under Inflation Targeting: Evidence from a Time-Varying Factor-Augmented Vector Autoregressive Model


Aye, Goodness C., Balcilar, Mehmet, Gupta, Rangan, The Journal of Developing Areas


(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The recent global economic and financial crisis between 2007 and 2009 which began as a subprime mortgage crisis is an episode in the history of the world that has heightened interest among policy makers and researchers. The crisis introduced a period of sustained uncertainty and volatility in world economic conditions. This crisis and its ensuing great recession broke the calm of the great moderation. The recovery from the crisis has been quite slow. The tensions due to the crisis raises questions about the suitability and effectiveness of the predominant policy framework - inflation targeting - employed by central banks around the world, including in South Africa (Marcus 2014).

The structural changes in many economies and the recent disruption of the era of "great moderation" by the financial crisis underlines the importance of understanding the nature and causes of the great moderation. This may assist policy makers in aiding its resumption. Three possible causes of the great moderation in South Africa were hypothesized by Burger (2008). These include better monetary policy, a more efficient financial sector, and improved inventory management. These three could be classified under the "structure and good policy" headings. His evidence supported two of the hypotheses, that is, better monetary policy and a more efficient financial sector contributed to greater economic stability, while better inventory management did not. This is consistent with earlier empirical evidence that monetary policy explains a large part of the great moderation in South Africa, with fiscal policy also contributing to this event (Du Plessis 2006; Du Plessis, Smit and Sturzenegger 2007, 2008). We will be considering the effectiveness of monetary policy pre- and post- the inflation targeting era.

The South African Reserve Bank (SARB) adopted the inflation targeting framework in February 2000 following the announcement by the Minister of Finance during the budget speech. Since then, the sole objective of the SARB has been to achieve and maintain price stability by aiming to keep the CPIX inflation rate within the target band of 3-6%, using discretionary changes in the short-term interest rate (Repurchase) rate) as its main monetary policy instrument. Aside the first and fourth quarter of 2016 when inflation went above the upper target (precisely 6.2%), it has remained within the target from 2016 to 2018 with the value for 2018: Q3 standing at 4.1% (SARB 2018). This may connote some success but how this translates to economic performance is a question that needs to be investigated.

A number of studies have investigated the effect of monetary policy on certain macroeconomic variables in some advanced countries but mostly in the US. The results are at best mixed as is evident in the literature review section. This paper assesses the impact of monetary policy shocks on the real, monetary and financial sectors of the African economy. This country specific analysis is important given that South Africa is a middleincome emerging economy while US where most studies have focused is an advanced and about the largest economy in terms of GDP per capita. Report by Economy (2019) shows that the US GDP per capita is about four times more than South Africa whereas inflation and unemployment in South Africa is about three times more than the US just to mention a few. Unlike South Africa, which adopted inflation targeting framework of 3 -6% as early as 2000, the US Federal Reserve Bank did not have explicit inflation target until 2012 when a target of 2% was set (Federal Reserve Bank 2015). However, U.S has always had a concern for keeping inflation low and as such regularly announced a desired target range for inflation of usually between 1.7% and 2%. Perhaps some similarities worth mentioning is that both economies have well developed financial markets and both are well integrated into the world economy and as such are very responsive to global shocks such as the recent global financial and economic crisis. …

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