Abstract
South Africa is currently running inflation targeting monetary policy since the year 2000 solely to achieve price stability. However, the persistent depreciation of the rand is making keeping inflation within the stipulated band very cumbersome. The objective of this paper is to find the duration taken by price indices to respond to exchange rate fluctuations. A Recursive VAR was used to investigate exchange rate passthrough (ERPT) to tradable prices in South Africa. Using monthly data, we find producer prices contributing highly to inflation with an average of 22% of fluctuations passed to prices. Large and persistent ERPT, especially on import and producer prices accompanied by high wage demands and a depreciating currency, are worrying factors for South Africa. Policy makers are advised to consider targeting the exchange rate if inflation is to be kept under control
Highlights
The monetary policy exchange rate channel is of paramount importance mostly for small and open developing countries like South Africa (South African Reserve Bank, 2002)
Exchange Rate Pass-Through (ERPT) can be divided into two stages, the first stage which is the transmission form exchange rate to import prices and second stage pass through which comes from the import prices to other prices down the pricing chain e. g consumer prices
We find producer prices highly responding to an exchange rate shock more than other tradable prices with a 22% response after an exchange rate shock
Summary
The monetary policy exchange rate channel is of paramount importance mostly for small and open developing countries like South Africa (South African Reserve Bank, 2002). The South African Reserve Bank (SARB) adopted inflation targeting monetary policy with a sole objective to stabilize prices in the country. This objective has been cumbersome to achieve mostly because of a persistently depreciating rand leading to passing through of exchange rate changes to prices assumed to be playing a huge role (Kabundi and Schaling, 2013). The transmission or consideration of the exchange rate changes to prices is defined as Exchange Rate Pass-through (ERPT) depending on the asymmetric behavior of price adjustments (Choudhri and Hakura 2015). When imports control a bigger part of the domestic market, the magnitude of exchange rate pass-through is expected to be very high since imports constitute a large portion of the consumption basket
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