Abstract
The floating exchange rate regime, coupled with a more open trade policy and the growth in imports, leaves South Africa vulnerable to the effects of exchange rate behaviour on import, producer and consumer prices, which all contribute to inflation. Given the central role that inflation targeting occupies in South Africa’s monetary policy, this paper examines the effect of exchange rate shocks on consumer prices using monthly data covering the period January 1994 to December 2013. Consistent with developing countries story, results show a modest exchange rate pass-through to inflation, although inflation is mainly driven by own shocks. The variance decompositions also reveal that foreign exchange rate shocks (REER) contribute relatively more to inflation than money supply shocks (M3). This suggests that South African inflation process is not basically influenced by money supply changes. The practical implication is that that the volatility of the rand is not a serious threat to inflation. The SARB should therefore focus on price stability and not be unduly worried about the volatility of the rand.
Highlights
Since 1980, South Africa has experienced three distinct monetary policy regimes
The causal relationship between Nominal effective exchange rate (NEER) and consumer price Index (CPI) and between reveal that foreign exchange rate shocks (REER) and CPI reflects the presence of exchange rate pass through to consumer inflation
This chapter analyzed the impact of exchange rate volatility on inflation in South Africa for the period 1994m1 to 2013m12, using Granger causality test within the framework of Toda-Yamamoto (1995) vector autoregressive (VAR) procedure
Summary
Since 1980, South Africa has experienced three distinct monetary policy regimes. During the first period (1980 to 1989), monetary policy was not successful in containing inflation. In February 2000, the South African Reserve Bank announced its aim to adopt an explicit inflation targeting monetary policy as an official target regime. This study will help to deepen literature on developing countries and to indirectly contribute to the current strong debate on the usefulness of inflation targeting monetary policy framework in South Africa. To this end, this paper analyses the impact of an exchange rate shocks on consumer prices in South Africa, using the Granger (non-) Causality Test, Impulse response functions and Variance decompositions within the Toda and Yamamoto’s (1995) VAR procedure.
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