Working Paper 134 - Inflation Targeting, Exchange Rate Shocks and Output: Evidence from South Africa
AbstractIn February 2010, the mandate of the South African Reserve Bank (SARB) was clarified with emphasis on taking a balanced approach, which considers economic growth when monetary policy authorities set interest rates. In the inflation targeting era, the SARB had left the exchange rate to be determined by market forces and this was accompanied by high levels of volatility. In this context, the study examines the differences in the responses of the real interest rate to the exchange rate shocks and inflationary shocks. At the same time, we examine how these shocks impact on output growth performance. Using a Bayesian sign restriction approach, the investigation assumes that the SARB has the desire to increase its foreign currency reserves in an unexpectedly high oil price environment. Our findings show that the real interest rate reacts negatively to inflation surprises and is not significantly different from zero in longer horizons, suggesting that the Fisher effect holds in the long-run. The paper shows that a strict inflation targeting approach is not compatible with a significant real output growth path. However, we found that under a flexible inflation-targeting framework, significant real output growth could be facilitated through attaching a larger role to the real effective exchange rate. The study, concludes that it is a measure of competitiveness relative to trading partners rather than smoothing the nominal exchange rate volatility levels which results in significant positive real output growth in the environment of accumulating reserves and uncertain high oil prices. The finding that the Fisher effect holds in the long-run indicates both the nominal interest rate and inflation rate have increased by nearly the same magnitudes confirming the effectiveness of monetary policy in the long run to mitigate inflation levels. Thus, a strict inflation targeting approach is not compatible with significant real output growth. However, in a flexible inflation targeting framework, the real effective exchange rate results in significant real output growth relative to Nominal Effective Exchange Rate (NEER) and bilateral exchange rate i.e. the Rand/US dollar. In policy terms, this implies focusing more on the exchange rate which deals with competitiveness relative to trading partners in an environment of reserves accumulation and uncertain high oil prices. Even under such circumstances monetary policy manages to control the inflationary pressures associated with such a shock.
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Bibliographic InfoPaper provided by African Development Bank in its series Working Paper Series with number 324.
Date of creation: 11 Aug 2011
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This paper has been announced in the following NEP Reports:
- NEP-AFR-2011-08-22 (Africa)
- NEP-ALL-2011-08-22 (All new papers)
- NEP-CBA-2011-08-22 (Central Banking)
- NEP-MAC-2011-08-22 (Macroeconomics)
- NEP-MON-2011-08-22 (Monetary Economics)
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