Inflation dynamics in South Africa: The role of public debt

Abstract

Orientation: Inflation targeting requires prudent fiscal policy to achieve desired results.Motivation for the study: Since the 2007–2008 financial crisis, fiscal authorities in South Africa have implemented an aggressive fiscal stimulus that has resulted in an acceleration of public debt, accompanied by a sustained government deficit. At the same time, the economy has continued to struggle with achieving significant growth to assist the government with its ever-growing expenditure obligations.Research Purpose: This study set out to investigate the relationship between inflation dynamics and the stance of fiscal policy, with a focus on public debt, in South Africa.Method: This study employs a New Keynesian dynamic stochastic general equilibrium (NKDSGE) model with financial frictions calibrated on South African data.Main Findings: The results of this study showed that when fiscal authorities put a relatively small weight on the control of public debt, inflation significantly increases in response to economic shocks. As a result, the cost channel of monetary policy transmission dominates the demand channel even if the loan rate pass-through is complete.Practical/Managerial Implications: The results of this study highlight the importance of fiscal discipline and its potential adverse effects on monetary authorities’ ability to achieve price stability as set out in their monetary framework.Contribution/Value added: To the best of our knowledge, this is the first study to analyse inflation dynamics and public debt in South Africa using modular experiments in a structural model derived from micro-economic foundations of constrained decision-making.