The determinants of inflation in South Africa: An econometric analysis
This study seeks to explain the dynamics of inflation in South Africa. It was motivated by the recent monetary policy shift towards inflation targeting and the authorities’ stated objective of reducing inflation to a level commensurate with that of its trading partners. In the study, we develop a model that relates domestic inflation in South Africa to money market, labour market and foreign exchange market conditions. We demonstrate that inflation in South Africa is largely a structural phenomenon. In the short run, there is a positive correlation between labour costs, broad money supply and domestic inflation. An appreciation of the rand or an increase in the nominal effective exchange rate will lower domestic inflation in South Africa. In the long run, rising labour costs contribute significantly to inflation. An increase in the nominal interest rate, the effect of which is insignificant in the short run, will slightly reduce inflation in the long run. On the other hand, an increase in the broad money supply will contribute to domestic inflation in the long run. It appears as if purchasing power parity exists between South Africa and its major trading partners. The predominant source of variation in domestic inflation’s forecast errors is own shocks. Innovations from labour costs and the nominal effective exchange rate are also important sources.The largely structural nature of inflation in South Africa, coupled with the reality that the monetary authorities have limited control over its main determinants, suggests that it will be difficult to achieve the objective of the inflation targeting regime, namely inflation parity with South Africa’s major trading partners.
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