Abstract
This paper attempts to capture the determination of the South African exchange rate in a theoretically plausible model with reliable forecasting ability. A sticky-price, Dornbusch-type monetary model of the rand/dollar exchange rate is proposed. The three-step Engle and Yoo cointegration procedure is applied and the test results indicate that the nominal exchange rate is cointegrated with relative real output, the relative money supplies and the inflation differential. An error correction model is estimated and shocks are applied to each of the long-run variables. Some policy implications are derived from these sensitivity tests. Finally, a fundamental equilibrium exchange rate (FEER) for the rand/dollar rate is defined and the FEER values are estimated until the year 2000.
Highlights
The South African currency unit has for some years been sensitized both politically and with respect to other fundamentals
Friedman (1953: 158) in his argument for flexible exchange rates, stated that: "The ultimate objective is a world in which exchange rates, while free to vary, are highly stable: Instability of exchange rates is a symptom of instability in the underlying economic structure"
Several South African policymakers have repeatedly confirmed their commitment to the government's comprehensive macroeconomic (GEAR) strategy
Summary
The South African currency unit (the rand) has for some years been sensitized both politically and with respect to other fundamentals. A model of the rand/dollar exchange rate is proposed. It conforms to the sticky-price Dornbusch version of the monetary model, and belongs to the assetapproach class of models. The validity of the monetary approach to exchange rate determination has been frequently questioned, due to the lack of empirical support reported by most researchers in the field. Irrespective of whether the monetary model's empirical failure stems from inadequate statistical techniques or fundamentally flawed theoretical content, its application to the South African exchange rate model requires some justification. The rand/dollar exchange rate is modelled, using the three-step Engle and Y00 cointegration technique and reporting the results thereof. Some relevant policy implications are considered and a fundamental equilibrium exchange rate (FEER) is proposed, given certain criteria for internal and external equilibrium
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