Working Paper 113 - Monetary Policy Conduct Based on Nonlinear Taylor Rule: Evidence from South Africa
AbstractThis paper utilized non-linear models to characterize the behavior of the Reserve Bank of South Africa using interest rate functions. Interest rate interaction functions have been formulated using the linear Taylor-rule since it is generally perceived that it renders a reasonable approximation to non-linear interactions. In essence, the Taylor rule tells us adjustments in the interest rate correspond to the deviation of output and inflation from their respective targets. In the US, for instance, the federal funds rate is raised by 1.5 percentage points for each 1 percentage point increase in inflation. The increase in federal fund rates raises real interest rates and reduces inflationary pressure. � Using a logistic smooth transition regression approach, the paper analyses the applicability of a nonlinear Taylor rule in characterizing the monetary policy behavior of the South African Reserve Bank. Analysis of movements in the nominal short-term interest rate for the period 1976 to 2008 shows that a non-linear Taylor rule holds. Contrastingly, other studies have characterized the South African Reserve Bank as following a linear Taylor-rule. However, the bulk of these studies have removed the structural break coinciding with the Asian Crisis and estimated two Taylor-rules. This study does not remove the anomalous structural break and thus uses the entire sampling period. However, our results are consistent with the findings of European Central Bank and the Bank of England. � The study contributes to current monetary policy debate by evaluating speed of transiting from low to high interest rate regimes in the context of emerging market economies. Furthermore, it evaluates the performance of linear and non-linear models in providing accurate forecasts and the existence of threshold levels of transition speed in decision making. The study evaluates the above by using the Diebold-Mariano (DM) and the Sign tests to determine the forecasting performance of the linear and non-linear models. The study employs a Smooth Transition regression model to explain the evolution of monetary policy over time. This approach permits the short term interest rate to react marginally to expected output and inflation gaps to adjust smoothly over the range of the reaction function. Several studies have used the same approach to examine the possibility of both non-linearity and structural change in the interest rate functions of Central Banks. South Africa’s monetary policy primarily focuses on an inflation objective and therefore seeks to achieve price stability. Quarterly data is derived from the International Financial Statistics (IFS) for the period 1976:1 to 2008:4. Data on the Treasury bill rate, inflation rate, output gap and real exchange rate is used to estimate the Taylor-rules. � The study finds that linear models perform better over long forecast horizons compared to non-linear models. Whereas non-linear models perform better over shorter forecast horizons in describing how the Central Bank responds to positive levels of inflation or an output gap relative their required targets. Using the full sample period, the study finds a 9 percent threshold level of inflation at signals a change in behavior by the Central Bank. Additionally, sample performance measures indicate that the non-linear model performs better in tracing out the data.
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Bibliographic InfoPaper provided by African Development Bank in its series Working Paper Series with number 250.
Date of creation: 11 Aug 2010
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- Nikolsko-Rzhevskyy, Alex, 2008. "Monetary Policy Evaluation in Real Time: Forward-Looking Taylor Rules Without Forward-Looking Data," MPRA Paper 11352, University Library of Munich, Germany.
- M Kesriyeli & D R Osborn & M Sensier, 2004.
"Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany,"
Centre for Growth and Business Cycle Research Discussion Paper Series
44, Economics, The Univeristy of Manchester.
- Mehtap Kesriyeli & Denise R. Osborn & Marianne Sensier, 2004. "Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany," Working Papers 0414, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
- Angelica E. Njuguna & Stephen N. Karingi & Mwangi S. Kimenyi, 2005. "Measuring Potential Output and Output Gap and Macroeconomic Policy: The Case of Kenya," Working papers 2005-45, University of Connecticut, Department of Economics.
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