A steady state QPM model for the South African economy

Policy makers of central banks in an inflation targeting framework need confidence in a model to forecast and analyse the key factors influencing the future rate of inflation. A model does not necessarily need to be sophisticated to ensure forecast consistency, and a great deal of innovative development in simplified modelling methods and techniques has taken place over the last few years. This study describes a small structural Quarterly Projection Model (QPM) as an addition to the South African Reserve Banks current suite of models for monetary policy purposes. The model differs from conventional models in that the coefficients are calibrated and the model has well defined steady state properties to generate a balanced growth path for the economy. At its core are four key equations: an aggregate demand or IS curve, a price setting or Phillips curve, an uncovered interest rate parity condition for the effective exchange rate, and a monetary policy reaction rule. The model expresses these variables in terms of their deviation (or gap) from their equilibrium levels and highlights the role of monetary policy in ensuring that the model projection returns to its long run equilibrium steady state. This essentially means that the emphasis in the QPM forecast now shifts to the reaction of monetary policy as it responds to the models exchange rate, inflation and real output projections. The study elucidates the use of the model and the calibration of the QPM, thereafter it is put through a battery of hypothetical temporary and permanent shocks to validate its structure. The research paper then concludes with an exercise on how the model can be used for forecasting purposes. The QPM was found to be successful in not only producing a reliable forecast, but also in its ability to provide a consistent explanation or economic coherent interpretation of a shock i.e. a model characteristic generally considered to be important in an inflation targeting environment.