Working Paper 169 - Monetary Policy and Exchange Rate Shocks on South African Trade Balance

This paper compares the effects of contractionary monetary policy and exchange rate appreciation shocks of one standard deviation in size, on the South Africa trade balance using recursive and sign-restriction vector autoregressive models. We find that an exchange rate appreciation shock lowers the trade balance as a percentage of the gross domestic product significantly, and over many quarters but not permanently relative to contractionary monetary policy shocks. These findings do not violate the neutrality of exchange rate effects in the long run economic growth. The contractionary monetary policy shocks affect the trade balance through the expenditure switching channel rather than the income channel. The real effective exchange rates explain relatively higher fluctuations in trade balance movements than monetary policy shocks. Both the exchange rate appreciation and monetary policy shocks worsen the trade balance through the imports rather than the exports component. Lastly, contractionary monetary policy worsens the trade balance at the peak in five quarters by more than 0.01 percentage points when allowed to directly affect the exchange rate relative to when its effect is left unrestricted.