Inflation Targeting, Exchange Rate Shocks and Output: Evidence from South Africa

Transcription

1 N o 134- Augus 2011 Inflaion Targeing, Exchange Rae Shocks and Oupu: Evidence from Souh Africa Mhuli Ncube and Eliphas Ndou

2 Ediorial Commiee Vencaachellum, Désiré (Chair) Anyanwu, John C. Verdier-Chouchane, Audrey Ngaruko, Floriber Faye, Issa Shimeles, Abebe Salami, Adeleke Coordinaor Salami, Adeleke Copyrigh 2011 African Developmen Bank Angle des l avenue du Ghana e des rues Pierre de Couberin e Hédi Nouira BP TUNIS Belvédère (Tunisia) Tél: Fax: afdb@afdb.org Righs and Permissions All righs reserved. The ex and daa in his publicaion may be reproduced as long as he source is cied. Reproducion for commercial purposes is forbidden. The Working Paper Series (WPS) is produced by he Developmen Research Deparmen of he African Developmen Bank. The WPS disseminaes he findings of work in progress, preliminary research resuls, and developmen experience and lessons, o encourage he exchange of ideas and innovaive hinking among researchers, developmen praciioners, policy makers, and donors. The findings, inerpreaions, and conclusions expressed in he Bank s WPS are enirely hose of he auhor(s) and do no necessarily represen he view of he African Developmen Bank, is Board of Direcors, or he counries hey represen. Working Papers are available online a hp:/ Correc ciaion: Ncube, Mhuli and Ndou, Eliphas (2011), Inflaion Targeing, Exchange Rae Shocks and Oupu: Evidence from Souh Africa, Working Paper Series N 134, African Developmen Bank, Tunis, Tunisia.

3 AFRICAN DEVELOPMENT BANK GROUP Inflaion Targeing, Exchange Rae Shocks and 0upu: Evidence from Souh Africa Mhuli Ncube and Eliphas Ndou (1) Working Paper No. 134 Augus 2011 (1) Mhuli Ncube and Eliphas Ndou are respecively Chief Economis and Vice Presiden of he African Developmen Bank, Tunis, Tunisia and Researcher a he Souh African Reserve Bank, Research Deparmen, Preoria, Souh Africa. This paper will also appear in he Reserve Bank of Souh Africa research papers" Office of he Chief Economis

4 Absrac This paper derives he inflaion equaion o search for a possible ransmission channel beween he real ineres rae, inflaion rae, exchange raes, real oupu growh rae using a Bayesian VAR sign resricion approach. Our findings show ha he real ineres rae reacs negaively o inflaion rae shocks and he Fisher effec holds in he long run. We show ha sric inflaion argeing approach is no compaible wih significan real oupu growh. However a flexible inflaion-argeing framework which aaches a large weigh o he role of real effecive exchange raes resuls in a significan real oupu growh given he Cenral Bank desire o accumulae more foreign exchange reserves and high oil price inflaion. Thus real effecive exchange rae measuring compeiiveness agains rading parners maers more han domesic currency and nominal effecive exchange rae depreciaions. JEL Classificaion: E31, E40, E52, E60 Keywords: Inflaion shocks, real ineres rae, sign resricion, oupu growh, inflaion-argeing

5 1. Inroducion Souh African moneary policy auhoriies have in several occasions managed o bring he inflaion rae wihin he arge band of 3-6% afer adoping inflaion argeing framework in February Economic growh in hese periods was no significan enough o reduce unemploymen rae. In February 2010, he mandae of he Souh African Cenral bank was clarified wih emphasis on aking a balanced approach, which considers economic growh when moneary policy auhoriies se ineres raes. In he inflaion argeing era, he Cenral Bank has lef he exchange rae o be deermined by he marke forces making i more volaile. Given his conex, we examine he differences in he responses of real ineres rae o he exchange rae shocks and inflaionary shocks, a he same ime we examine how hese shocks impac on oupu growh performance. Moreover we invesigae assuming ha he Cenral Bank has desire o increase reserves accumulaion and unexpeced high oil prices environmen using Bayesian sign resricion approach. Inflaion argeing is eiher sric or flexible, depending on he specified loss funcion of he cenral bank. Under sric inflaion argeing, he cenral bank is only concerned abou keeping inflaion close o an inflaion arge over he shorer horizon (Svensson 1997b). This requires very vigorous acivis policies, which involve dramaic ineres rae and exchange rae changes. This happens wih considerable variabiliy of exchange raes, ineres raes, oupu, employmen and domesic componen of inflaion. To some exen he acivism probably sabilize inflaion around he inflaion arge. Flexible inflaion argeing occurs when he cenral bank gives some weigh o he sabiliy of ineres raes, exchange raes, oupu and employmen o bring inflaion o he desired long run arge over longer horizon. I requires less policy acivism which gradually reurns he inflaion back o arge over a longer horizon. 1 Immediaely afer adoping inflaion argeing approach applying a sricer approach clearly demonsraes he commimen o he inflaion arge, builds credibiliy more quickly, and is more appropriae a he iniial phase of disinflaion. However Svensson (1997b) argues ha, afer he bank has demonsraed commimen and esablished credibiliy o a reasonable degree, here may be more scope for flexibiliy wihou endangering credibiliy. Mos policy rae reacion funcions for Cenral Banks in an open economy framework have oupu gap, inflaion gap and exchange rae gap as explanaory variables. Following similar specificaion in lieraure, Granville and Mallick (2010) using moneary policy rule for an open economy esed empirically he reacion of he ineres rae o exchange rae changes and inflaion rae shocks. Esimaion incorporaed assumpions ha he cenral bank has a desire o 1 Flexible inflaion argeing successfully limied no only he variabiliy of inflaion bu also he variabiliy of he oupu gap and he real exchange rae (Svensson 1997b). -5-

6 accumulae more reserves even under a negaive supply shock in form of higher oil prices. They imposed sign resricions o idenify exchange rae shocks and inflaion shocks o examine impulse responses funcions. They found, using an error correcion form and a sign resricion approach ha Russian moneary auhoriies focused more on argeing he exchange rae raher han inflaion as an insrumen for moneary policy. Firsly, his paper fills he gap in he lieraure on emerging markes such as Souh Africa, by using a Bayesian sign resricion idenificaion sysem o search he ype of moneary policy he Cenral bank should adop o suppor significan economic growh under flexible inflaion argeing. Secondly, he paper shows ha sric inflaion argeing approach has a differen growh pah compared o he pah under flexible inflaion argeing framework, in which significan economic growh could be faciliaed hrough a larger role aached o a paricular exchange rae measure. Thirdly, we also idenify he paricular measure of exchange rae ha is compaible wih significan economic growh. Lasly, we derive he price formaion equaion and use he variables in he equaion o show ha exchange rae can be used o simulae significan economic growh. Recenly, here has been grea ineres in models using large daases based on facor analysis 2 founded on saic facors in Bernanke e al (2005) and recenly he dynamic facors in Forni and Gambei (2010) and large Bayesian models by Banbura (2010). Facor analysis uses more informaion, however Forni and Gambei (2010) exposiion suggesed ha saic facors may no have any economic inerpreaion and here are ofen difficulies on he resricions o be saisfied by hese facors according o heory. However, he above menioned large daases mehodologies are no appropriae, based on meris of his sudy. According o Fry and Pagan (2007) sign resricions have provided a useful echnique for quaniaive analysis, especially when variables are simulaneously deermined, making i harder o jusify any parameric resricions o resolve he idenificaion problem. However, Scholl and Uhlig (2008) rejeced o embrace Fry and Pagan (2007) argumen relaed o median impulse response in sign resricions as an issue arising generally wih all idenificaion procedures. Even he laer admis idenificaions issues affec all forms of VARs no only hose using sign resricions. We adoped he sign resricion approach of Granville and Mallick (2010) for his analysis. The Bayesian sign resricion mehodology has advanages over ordinary Vecor Auoregresion (VAR). From a mehodological perspecive, Frazscher e al (2010) argues ha sign resricion gives resuls independen of chosen decomposiion of variance covariance marix. This implies ha differen ordering does no change he resul. Furhermore, his mehod involves a simulaneous esimaion of boh reduced-form VAR and he impulse vecor. Tha is, he draws from he VAR parameers from he unresriced poserior ha do no saisfy he sign resricion, 2 Facor models being parsimonious can model a large amoun of informaion whereas in small VARS he number of variables canno be enlarged because of boh esimaion and idenificaion problems. Bernanke B, Boivin J, Eliasz P (2005) suggesed ha he naural soluion o he degrees of freedom problem in VAR analyses is o augmen sandard VARs wih esimaed facors. Forni and Gambei (2010) criicised BBE (2004) idenificaion suggesing his saic facors approach hrough considering facors which are linear combinaions of slow-moving variables a he same ime excluding fas-moving variables resuls in an efficiency loss. -6-

7 receive a zero prior weigh. Granville and Mallick (2010) argue ha he sign resricion mehod is robus o non-saionariy of series including srucural breaks. The advanage is ha sign resricion idenificaion allows shocks o be idenified using mild resricions on muliple ime series. Rafiq and Mallick (2008) sugges resricions imposed should happen irrespecive of how hese inflaion, exchange rae variables are measured and heir daa idiosyncrasies, suggesing ha definiions and measures of same class of variables used are of secondary imporance. 3 Furhermore, he sign resricion mehodology does no pu any quaniaive resricions on he impulse responses. A pure sign resricion approach makes explici use of resricions ha researchers use implicily and are herefore agnosic (Rafiq and Mallick 2008). 4 The sign resricions adoped from Granville and Mallick (2010), suggess ha he oil price does no decrease as an exogenous posiive shock, and he change in foreign exchange reserves excluding gold does no decrease in response o oil inflaion. Inflaion does no decline in response o is own shocks. The paper uses hree exchange raes where he posiive sign on he nominal Rand per US dollar implies depreciaion of he local currency and he negaive sign on boh real and nominal effecive exchange raes imply depreciaions. The sign resricions imposed suggess ha he Rand per US Dollar exchange rae will no decline whereas he nominal and real effecive exchange rae should no rise in response o heir own shocks. Moreover, hese exchange raes depreciaion shocks occur due o own innovaions, changes in foreign exchange reserves and wih oil price inflaion. Our findings show ha he real ineres rae reacs negaively o inflaion surprises and is no significanly differen from zero in longer horizons suggesing ha he Fisher effec hold in he long run. The paper showed ha sric inflaion argeing approach is no compaible wih significan real oupu growh pah. However, we found ha under a flexible inflaion-argeing framework, a significan real oupu growh could be faciliaed hrough a larger role aached o he real effecive exchange rae. The sudy, concludes ha i is a measure of compeiiveness relaive o rading parners raher han smoohing he nominal exchange rae volailiy levels which resuls in significan posiive real oupu growh in he environmen of accumulaing reserves and uncerain high oil prices. We srucure he paper such ha Secion 2 reviews he lieraure evidence showing ha oher variables including he inflaion rae maer for he Cenral Banks. In secion 3, we derive he inflaion equaion, which shows he relaionship amongs variables. Secion 4 presens he daa, mehodology and describes he sign resricion approach. Secions 5 gives he resuls from pure sign resricion approach and summarize he findings from he penaly funcion. Secion 6 gives he conclusion. The paper has addiional graphs in he Appendices. 3 For example he differen measures of inflaion rae e.g. core inflaion and headline inflaion. Money measures M3 or M1 or M2 4 As shown in Uhlig (2005) he sign resricion can avoid puzzles by design, for example, price puzzle was avoided by consrucion. -7-

8 2. Lieraure review This secion highlighs evidence from inflaion argeing regimes showing ha variables oher han inflaion maer for policy makers, especially in he commodiy exporing counries. Inflaion argeing is divided ino wo broad groups, namely sric inflaion and flexible inflaion argeing. Sric inflaion argeing suggess ha he only concern of he cenral bank is o sabilize he inflaion. I requires vigorous and more acive policy changes, involving dramaic changes in ineres and exchange raes. Flexible inflaion argeing is when he cenral bank gives some weigh o he sabiliy of ineres raes, exchange raes, oupu and employmen (Svennson 1997b). The policy is conduced in such a manner ha he condiional inflaion forecas approaches he inflaion arge more slowly. The inflaion forecas equals he inflaion arge a a longer horizon. Evidence showed ha flexible inflaion argeing successfully limied he variabiliy of inflaion, he variabiliy of he oupu gap and he real exchange rae. In conras, Aghion e al. (2009) showed ha exchange rae volailiy reduces produciviy in developing counries, aribuing i o financial channels. The findings showed he adverse effecs of exchange rae volailiy were larger for he less financially developed counries and are significan for pracically all he emerging markes and developing counries. Recen sudies have reviewed wheher cenral banks pracice flexible inflaion argeing. Cecchei and Ehrmann (2000) compared cenral bank behaviours in 23 indusrialised and developing economies including 9 ha arge inflaion explicily. They found ha inflaion argeers exhibied increasing aversion o inflaion variabiliy and decreasing aversion o oupu variabiliy. Moreover, hey show ha inflaion argeing counries were able o reduce inflaion volailiy a he expense of an increase in oupu variabiliy. Aghion e al (2009) esed wheher emerging markes follow pure inflaion argeing rules or ry o sabilize real exchange raes. Their findings indicaed ha inflaion argeing markes praciced a mixed inflaion argeing sraegy. Inflaion argeing cenral banks responded o boh inflaion and real exchange raes in seing ineres raes. In addiion, hey find he sronges response o real exchange rae in counries following inflaion argeing policies which are relaively inensive in exporing basic commodiies. A few sudies esimaed explicily he Taylor rule equaions for individual counries. Aizenman e al (2008) sugges ha emerging markes which adoped inflaion argeing were no following pure inflaion argeing sraegies. They found evidence showing ha exernal variables played a very imporan role in he Cenral bank s policy reacion funcions. Cenral banks respond o real exchange rae. In addiion, inflaion argeers wih high concenraion in commodiy expors change ineres rae in a proacive manner in response o real exchange rae han non-commodiy inensive group. Corbo e al (2001) found mixed evidence from seveneen OECD counries esimaed individually. Their resuls showed ha inflaion argeers exhibied he larges inflaion coefficiens compared o he oupu gap coefficiens. Lubik and Schorfheide (2007) esimaed Taylor ype rules in which auhoriies reaced o oupu, inflaion and exchange raes. The -8-

9 findings reveal mixed responses indicaing he Ausralian and New Zealand cenral banks changing ineres raes in response o exchange rae movemens. In conras he Canadian did no respond o exchange raes. De Mello and Moccero (2010) esimaed ineres rae policy rules for Brazil, Chile, Colombia and Mexico under he inflaion argeing and floaing exchange raes in The ineres rae policy rule was formed in he conex of he new Keynesian srucural model wih inflaion, oupu and ineres rae. Their findings sugges a sronger and persisen response o expeced inflaion in Brazil and Chile in he pos 1999 inflaion argeing period. In Colombia and Mexico moneary policy has become less couner-cyclical. Minella e al (2003) esimaed a reacion funcion for he cenral bank of Brazil, and showed ha he coefficien on oupu gap is no saisically significan in mos of he specificaions. Pavasuhipaisi (2010) develops a DSGE model ha also concludes ha inflaion argeing regimes should respond o he exchange rae shocks under cerain condiions ha he paper oulines. Findings from heir ess showed ha he policy rule adoped by inflaion argeing commodiy-inensive developing counries differed from ha of he inflaion argeing non-commodiy exporer. These finding give suppor o he greaer sensiiviy of commodiy inflaion argeing counries o exchange rae changes. We derive he inflaion equaion and policy reacion rule in conex of an open economy in he nex secion. We do no esimae boh he policy reacion funcions and inflaion equaions in a univariae seing. Raher we pursue a mulivariae approach by esimaing he enire srucural model using a Bayesian sign resricion approach wih variables from boh equaions. 3. The inflaion equaion framework Before we search for a possible relaionship beween he real ineres rae, inflaion rae, exchange rae, foreign exchange reserves excluding gold growh and oupu growh (proxied by growh in manufacuring producion) and oil prices, we derive he cenral bank price formaion equaion. The price formaion equaion is formed in he conex of open economy suggesing ha he exchange rae play an imporan role in decisions affecing demand and supply disurbances. Thus, we use he variables in he inflaion equaion and impose resricions on hem, assuming he inflaion equaion is followed by he cenral bank. The cenral bank has aached less weigh o he role of exchange rae under he sric inflaion-argeing framework which is expeced o change under flexible inflaion argeing framework. 3.1.Deriving he inflaion equaion We adop he approach of Granville and Mallick (2010) o derive he inflaion equaion and reacion funcion of moneary policy which includes he changes in flow of money ( MS ) decomposed ino inernaional reserves ( IR ) and domesic asses ( DA ) -9-

10 [1] MS IR DA Chamberlin (2006) showed ha changes in inernaional reserves can be expressed in erms of he rade balance. However we adjus he equaion o ake care of he imperfec capial mobiliy. [2] IR X M ) K ( r d r f e e ) ( The rade balance is given by expors ( X ) minus impors M ) and capial flows K ) is deermined by he difference beween domesic ineres rae ( r d ) and foreign ineres rae ( f ). 5 A rade balance surplus suggess ha he Cenral Bank is adding o reserves accumulaion. e e ) refers o he expeced change in nominal bilaeral exchange rae. An expecaion of rand ( appreciaion agains he US dollar would lead o capial inflows. A posiive ineres differenial which simulaes capial inflows should appreciae domesic currency leading o increased reserve accumulaions. However he ne effec of currency appreciaion on reserves accumulaion is unclear due o asymmery effecs. Currency appreciaion lowers expors and i becomes cheaper o purchase foreign currency ceeris paribus. The flow of money demand ( MD ) for an open economy funcion depends on he level of real oupu ( y ), exchange rae ( e ) and real ineres rae ( r ). The real ineres rae is given by he difference beween he nominal ineres e e rae ( i ) and expeced inflaion ( ) i.e r i. The fisher effec suggess in he long run, real ineres raes should no change because boh he nominal ineres rae and inflaion rae would have changed by same percenage. We argue ha since real ineres rae is a linear combinaion of wo non-saionary variables, i can be saionary in line wih oher firs differenced variables hence his jusifies i being lef in levels. [3] MD y r e v and,, 0 These variables have been log-differenced and expressed in percenages and he real ineres rae lef in level. Equaion [3] shows ha ransacion demand for nominal balances increases as he expeced inflaion levels increases. The expeced rae of depreciaion in he money demand funcion capures he porfolio choice ha asse holders face. The exchange rae changes may increase or reduce he demand for money due o subsiuion effec or he wealh effec (Hye e al 2009). According o Sriram (2001) he expeced depreciaion will have a negaive effec on money demand. Thus, an increase in expeced depreciaion ranslaes ino higher expeced reurns from holding foreign money hence agens will subsiue domesic currency for foreign ( ( r 5 Balance of paymens surplus = increase in official exchange reserves = curren accoun surplus+ ne capial inflow. Expors depends on exchange rae and foreign income whereas impors depends upon exchange rae and domesic income. Subsiuing he bilaeral nominal d f e exchange rae as defined in Blanchard (2006) e ( 1 r ) (1 r ) e sugges a direc negaive relaionship beween high domesic ineres, expeced appreciaion and lower foreign ineres rae hence rade balance will deeriorae. -10-

11 currency. 6 The effec of ineres rae on demand for currency would be negaive wih an increase in ineres rae and posiive for ineres bearing demand and ime deposis (Kalra 1998). Conversely, higher real raes of reurn on alernaive asses reduce he incenive o hold money hence he negaive relaionship beween money and reurn on alernaive asses (Sriram 2001). Money demand is expeced o be posiively relaed o he level of aciviy. Assuming equilibrium in he money marke holds coninuously suggess ha ( MD MS ). Hence we can wrie he capial flow reacion equaion as [4] DA y r e IR The inverse relaionship beween changes in inernaional reserves and domesic asses implies ha under flexible rae exchange policy, currency changes are likely o influence he conduc of moneary policy while under fixed exchange raes he bank should serilize capial inflows o hold money consan. In equaion [4] domesic residens may also hold foreign currency for ransacions or precauionary purposes in he presence of domesic inflaion meaning ha domesic currency depreciaion may lead o declines in real money balances encouraging currency subsiuion (Granville and Mallick 2010). Choudhry (1998) found ha he rae of change in exchange rae should be included in demand equaion for M2 o obain a saionary long run relaionship. Bahmani-oskooee (1991) included he effecive exchange rae measure in he money demand equaion. The aggregae inflaion ( ) supply equaion can be formulaed on he basis of an open economy Phillips curve, as done in Granville and Mallick (2010) 0 [5] y e DA Domesic asses erm suggess ha if he currency does no change in response o changes in capial inflows, hen an increase in money growh can conribue o generaing inflaion ( ). We also include he oil price ( ) in order ake ino accoun he exernal oil price shocks as a source 0 of inflaion pressures. Therefore subsiuing equaion [4] ino equaion [5] gives 0 [6] ( ) y r ( ) e IR ( ) The equaion suggess inflaion should go down as real ineres rae increases; should rise as currency depreciaes; and inflaion can be reduced when inernaional reserves increase by allowing currency o appreciae flowing capial inflows when he cenral bank does no serilize he capial inflows. The negaive effec of inernaional reserves accumulaion can be neuralised 6 Kalra (998) sugges ha a- priori he sign on expeced depreciaion in indeerminae and depends on wheher broad money is defined o include or exclude foreign currency denominaed deposis The inclusion of broad money is defined o include foreign currency deposis. Therefore an expeced depreciaion in he exchange rae could induce a migraion ino foreign currency denominaed asses hence he shif in he composiion of broad money owards foreign currency denominaed asses implying coefficiens on exchange rae is posiive. In conras a shif o foreign currency conribuing negaive componen o exchange rae changes. -11-

12 by currency depreciaion. The dominance of he laer over reserves accumulaion can lead o inflaion. The moneary policy auhoriies deermine he ineres raes, increasing i o lower inflaion rae via moneary conracion and giving lile weigh o exchange raes hence esablishing a rade off beween he exchange rae and inflaion. For an open economy, he Taylor rule can be wrien for he unobservable equilibrium real ineres rae o include exchange raes [7] r y ( *) e The parameers, and give he size of he response of moneary policy measured by ineres rae o oupu, inflaion gap and changes from exchange raes. The inerpreaion of he reacion funcion suggess ha real ineres rae is increasing in he excess of inflaion rae over he inflaion arge, in curren oupu and exchange rae depreciaion. Growh in money declines in equaion [3] as real ineres raes increase, hence sabilising inflaion rae in Phillips equaion. Granville and Mallick (2010) sugges ha Fisher effec holds when he real ineres rae should no change in response o changes in inflaion. Alernaively he inflaion rae can have one o one posiive effec on he nominal ineres rae. Also he exchange rae depreciaions can produce an increase in real ineres rae and heir simulaneous inclusion will herefore disenangle heir effecs on he real ineres rae. This paper derives he aggregae supply equaion which is formulaed following he open economy Phillips curve. This formulaion defines he inflaion rae in erms of foreign exchange reserves, oil price shocks, real ineres rae, exchange rae and oupu. The focus of his analysis differs from he research aim done by Granville and Mallick (2010). We impose resricions on he idenified variables in he aggregae supply equaion for a differen purpose o ha of Granville and Mallick (2010). The paper assesses which policy shocks beween differen exchange rae shocks and inflaion rae shocks can achieve posiive real oupu growh raes given variables in he inflaion equaion in Souh Africa and he cenral bank mainenance of price sabiliy remaining essenially. 4. Bayesian VAR model and idenificaion 4.1. VAR model We esimae he inflaion shocks and hree exchange rae depreciaion shocks in Souh Africa in he framework of VAR. The sign idenificaion sars wih he esimaion of a reduced-form VAR equaion [9]. For simpliciy we omied he inercep erm and dummies. [8] Y BY 1 u Where Y is an n 1 vecor of daa series a dae 1,2,..., T where B=[B 1, B 2,. B p ] is he vecor of marix of lagged coefficiens and u is he one-sep ahead predicion error and he -12-

13 variance-covariance marix is. Assuming independence of fundamenal innovaions, we need o find marix A which saisfies u A. The j h column of A, ha is j represens he immediae impac on he variables of he j h fundamenal shock equivalen o one sandard deviaion in size on he n-endogenous variables in he sysem. Hence he variance covariance is given by E( u u ) AE( ) A AA. To idenify A, we need a leas n(n-1)/2 resricions on A. The reduced form disurbance are orhogonalised by Cholseky decomposiion, which use recursive srucure on A making i lower riangular marix Pure sign resricion We adop he Bayesian sign resricion approach (see Uhlig (2005) Mounford and Uhlig (2009), Frazscher e al (2010)) o idenify he VAR model hrough imposing sign resricions on he impulse responses of a se of variables. The idenificaion here searches over he space of i possible impulse vecors A o find hose impulses responses which agree wih he sign i n resricions. The aim is o find impulse vecor a where a R, given ha here is an n- ~ dimensional vecor q of uni lengh so ha a Aq where A ~ A ~ and A ~ is a lower riangular Cholesky facor of. The firs par of secion 5 repors resuls of individual idenified fundamenal shocks. We show ha he impulse responses for n-variables up o horizon S can be calculaed for a given impulse vecor a j, afer esimaing coefficiens in B using he ordinary leas squares. The unique impulse response funcion is given by equaion [8] as done in Frazscher e al (2010) 1 [9] rs [1 B] a j The r s denoes he marix of impulse responses a horizon S. Sign resricions are imposed on a subse of he n variables over horizon 0,1,..., S such ha he impulse vecor a j idenifies he paricular shock of ineres. The esimaion of impulse responses is obained by simulaion. n Given he esimaed reduced form VAR, we draw q vecors from he uniform disribuion in R divided i by is lengh o obain a candidae draw for a j and calculae is impulse responses while discarding any q where he sign resricions are violaed. The esimaion and inferences is done as explained below. In he sign resricion approach a prior is formed for he reduced form VAR model. Using he Normal-Wishar in ( B, ) as he prior implies he poserior is he Normal-Wishar for ( B, ) imes he indicaor funcion on Ãq. The indicaor funcion separae draws which saisfied he sign resricion from hose which fail o do so. A join draw from he poserior of he Normal-Wishar for ( B, ) and draws from he uni sphere are drawn from poserior disribuion o ge a candidae q vecors. We use he draws from he poserior o calculae he Cholskey decomposiion as imporan compuaional ool raher han shocks idenificaion ool. From each q draw we compue he associaed a j vecors and impulses responses and hese impulses are subjec o furher selecion. For hose impulse responses which -13-

14 saisfy he sign resricions he join draws on ( B,, a) are sored oherwise hey are discarded. The error bands are calculaed from draws kep from 1000 draws which saisfy he sign resricions. As such, his firs par focuses on esimaion of one shock. The second par of secion 5 repor he impulse responses of wo idenified fundamenal shocks, ha is, k 2. The above approach is exended o include wo shocks. As such, we characerize (1) (2) he impulse marix [ a, a ] as of rank 2 raher han all of A in robusness es. We impose he resricions based on economic prior s expecaions on he impulse responses ogeher wih resricions ha ensure orhogonaliy of he fundamenal shocks. By consrucion he covariance beween fundamenal shocks fundamenal shocks are orhogonal. (1) (2), corresponding o -14- (1) (2) a,a is zero meaning ha hese Hence any impulse marix [ ( 1) ( )... k (1) ( ) a a ] can be wrien as produc [ a... a ] q AQ of he lower k ~ riangular Cholesky facor A ~ ( 1) ( k) ( j) of wih k x n marix Q [ q... q ] of orhonormal rows q such ha QQ I k. This is a consequence of noing ha A ~ A ~ 1 mus be an orhonormal marix for any decomposiion A ~ A ~ of. Denoing (s) a a where s 1,2,... n represens a column of he impulse marix. We also denoe q ( s) ~ 1 ( s) q A q as he corresponding column of Q. Therefore he impulse responses for he impulse vecor a can be wrien as a linear combinaion of he impulse responses o he Cholesky decomposiion of in a way described below. Denoing i (s) o be he impulse response of he r j h j variable a horizon s o hei h column of A ~, and he n-dimensional column vecor r k) [ r,..., r ]. The n-dimensional impulse response r as a horizon s of impulse vecor [10] ras qir n i 1 where q i is he i h enry of ~ ~ a ( 1) A q (1) and ( 2) A q (2) is (s) q q. We idenify i ( 1i ni (s) a is given by (1) (2) a, a using he appropriae sign resricions a a he same ime joinly impose orhogonaliy condiions in he (1) (2) form q q 0 and q q 0. In general a join draw is aken from he poserior of he Normal- Wishar for ( B, ) o obain he candidae q vecors. Each draw for q ha saisfy he above resricions is kep oherwise i is discarded. The error bands are calculaed from draws sored from draws which saisfy he sign resricions. Pure sign resricion approach makes explici use of resricions ha researchers use implicily and are herefore agnosic. We use he penaly funcion approach o es he robusness of he resuls from boh single shocks. Moreover we replace reserves excluding gold wih foreign exchange. The penaly funcion developed by Uhlig (2005) rewards responses ha are consisen wih he resricions

15 and penalizes heavily hose violaing he resricions. Unlike he pure sign resricion approach, he penaly funcion uses addiional resricions which lead o possible disorion of he rue direcion of he responses from he imposed sign resricions. We use pure sign resricions in main body of he paper and penaly funcion approach in robusness analysis The empirical model We adoped Granville and Mallick (2010) sign resricion idenificaion approach which is robus o boh non-saionariy of he series including breaks. The exchange rae and inflaion rae shocks effecs are resriced o las a leas K=6 monhs. We argue ha he moneary policy auhoriies reacion o hese variables has implicaions on he oupu sabilisaion oucomes. Sric inflaion argeing does no aach any weigh o oupu gap sabilisaion. The insrumen is se such ha condiional inflaion forecas equals he inflaion arge. Any shocks causing deviaions beween he condiional inflaion forecas and he inflaion arge are me by an insrumen adjusmen ha eliminaes he deviaion. In conras, flexible inflaion argeing aaches a posiive weigh on oupu gap sabilisaion, ineres rae, real exchange rae and inflaion. The policy insrumen under flexible inflaion argeing is adjused such ha condiional inflaion forecas approaches he long run inflaion gradually, minimising flucuaions on oupu gap, exchange rae and ineres raes. The larger he weigh aached on oupu gap sabilizaion, he slower he adjusmen of condiional inflaion forecas owards he long run inflaion arge. The role of exchange rae in an open economy framework is imporan in he moneary ransmission mechanism. Real exchange raes affec aggregae demand channel of he moneary ransmission of moneary policy. I affecs he relaive prices beween domesic and foreign goods and foreign demand for domesic goods. The direc exchange rae channel for moneary policy ransmission, affecs inflaion hrough domesic price of impored goods and inermediae inpus, which are componens of consumer price inflaion. In addiion, i affecs nominal wages via he effec on inflaion on wage seing, he foreign demand for domesic goods which impac on he aggregae demand for domesic goods. Based on hese conclusions we idenify wo main shocks, namely; he exchange rae depreciaion shocks, which has boh inflaionary effecs and growh effecs in he economy, and he inflaion shock, by imposing hree sign resricions for each shock, in he following way: Table 1. Sign resricions for inflaion and exchange rae shock r IR e y Inflaion? +?? + + Rand?? +? + + REER?? -? + + NEER?? -? + + NB. The? indicaes he variable was lef unresriced whereas (-)/+ implies (negaive)/ posiive effecs 0-15-

16 Firsly, he sign resricions imposed sugges ha, he oil price does no decrease as an exogenous posiive shock. Secondly, he change in foreign exchange reserves does no decrease in response o oil inflaion or exchange rae depreciaions. The sudy uses hree exchange raes. The posiive sign on he Rand price of one dollar implies depreciaion of he rand. However, he negaive sign on boh he real effecive exchange rae and nominal effecive exchange rae imply depreciaion. Thirdly, he rand per dollar exchange rae change will no decline in response o is own posiive shock whereas boh nominal and real effecive exchange raes should no rise afer depreciaion shock. We assume hese exchange rae depreciaions should occur due o own innovaions and changes in reserves and oil price inflaion. The overall inflaion does no decline in response o is own shock. Souh African foreign exchange reserves excluding gold accumulaion increased since he adopion of he inflaionargeing framework. Therefore, a moneary or inflaion shock can emerge from changes in reserves growh or due o oil price inflaionary shock. Domesic currency depreciaion makes domesic expors cheaper relaive o impored goods and can lead o rising inflaion raes. Higher demand for domesic goods parly due o increased expor demand can increase indusrial producion. However we refrain from prejudging his oucome and le impulse responses reveal i. Moreover, exchange rae changes can be eiher an appreciaion or depreciaion depending on he direcion of change. These asymmeric oucomes are equally likely under he pure sign resricion. However, his mehod keeps hose impulse vecors which saisfy he imposed sign resricion while discarding hose violaing hem in response o a uni shock innovaion. 4. The Daa The sudy uses monhly daa from January 2000 o January 2010 under he inflaion-argeing regime. 7 We use six variables namely, he growh in foreign exchange reserves excluding gold, oupu growh approximaed by manufacuring producion growh, inflaion rae, growh in nominal rand, nominal effecive exchange rae (NEER), real effecive exchange rae (REER), growh in oil price index and real ineres rae. We use daa exraced from he Inernaional Moneary Fund IFS daabase. We use hree measures of exchange rae namely, he nominal rand per US dollar (R/$), NEER and REER in separae esimaions. The real ineres rae equals he difference beween nominal ineres rae and expeced inflaion rae. We calculae he expeced inflaion rae using he mehodology in Davidson and Mackinnon (1985). 8 Boh he inflaion rae and expeced inflaion rae display similar rends in figure A1 in Appendix A. We calculaed he 7 The percenage calculaed using he year on year percenage changes approach alers he saring period. The esimaion period sars from January 2001 raher However we need he observaion from We adoped Davidson and Mackinnon (1985) mehod. The procedure firs calculaed he weighed inflaion rae using his following equaion. Weighed inflaion w Then regress inflaion ( ) on he consan, weighed inflaion rae ( w ) and rend. The forecas inflaion rae from he regression becomes he expeced inflaion. The real ineres rae ( r ) is given by difference beween nominal ineres rae ) e ( i and expeced inflaion ( ) i.e -16- r i e

17 growh raes as year on year percenage changes. 9 A posiive increase in REER and NEER represens appreciaion respecively and domesic currency depreciaion. Figure 1 shows he variables annual percenage changes excep he real and nominal ineres raes which are in levels. For mos periods under review, he manufacuring index has grown by nearly 5% beween 2003 and 2008 and conraced by 16% in 2009 due o recession. The consumer price inflaion, nominal ineres raes and expeced inflaion raes variables move closely ogeher wih he regimes of lower raes of changes and higher raes of changes coinciding on same periods. Higher inflaion raes, expeced inflaion raes and nominal ineres raes occurred in and wih lower raes in and afer The nominal ineres raes remained above he 6% lower bound whereas he real ineres raes remained posiive for mos periods excep in 2008 and 2009 showing ransiory negaive values. Oil price inflaion displayed huge upward and downward movemens beween 2007 and In annual erms, he oil price increased by more han 50% in 2008 and declined by nearly 75% from he fourh quarer of 2008 o he second quarer of In he las quarer of 2009, i increased by nearly 50% due o low base effecs in he previous year. Reserves excluding gold and foreign exchange growh rae were negaive before 2003 reflecing he period in which he Souh African Reserve Bank closed he forward book. Moreover, higher growh raes beween 2004 o early 2005 refleced low base effecs in previous years, hereafer Cenral Bank gradually coninued o acquire reserves. All hree exchange raes depreciaions end o be persisen in he periods; 2000 o 2002, mid-2006 o early-2007, lae-2007 o early The exchange raes appreciaion periods includes he periods of lae-2002 o early-2005 and from second quarer of For example, he inflaion rae ( ) is calculaed using formula 100 (log( cpi cpi 12) -17-

18 Figure 1. Plo of variables Changes in Manufacuring index (%) Nominal ineres rae (%) Consumer price level inflaion (%) Changes in NEER (%) Oil price inflaion (%) Changes in REER (%) Changes in Toal Reserves minus Gold (%) Real Ineres Rae (%) Changes in Foreign Exchange (%) Expeced Inflaion Rae (%) Changes in Rand-dollar (%) Table 2 shows he descripive saisics of all variables, in paricular he mean, sandard deviaion, minimum and maximum values. Oil price inflaion has he highes sandard deviaion value indicaing ha i is he mos volaile variable wih boh he minimum and maximum growh rae exceeding 65%. All he hree exchange rae measures show ha he exchange raes deviae from heir means by 15-21%, which is higher han deviaions of boh inflaion, expeced inflaion and ineres raes. The reserves excluding gold as well as foreign exchange show deviaions from he mean growh raes of abou 20%. These percenage deviaions from boh reserves and foreign exchange mean growh raes exceed percenage deviaion of CPI inflaion rae, nominal ineres rae, real ineres raes and expeced inflaion rae. In erms of mean growh raes reserves excluding gold and foreign exchange experienced average growh raes of a leas 18% which are he highes growh raes compared o all oher variables possible indicaing he acive accumulaion of boh reserves and foreign exchange by he Reserve Bank. The growh in manufacuring volume index is exremely low and being less han 1% over he period and is deviaion from he mean is nearly 7 possible reflecing huge negaive effec of he recession in

19 Table 2. Descripive saisics Variable Mean Sd Error Minimum Maximum Nominal ineres rae CPI inflaion rae Oil price index inflaion rae Rand NEER REER Manufacuring Index Reserves excluding gold Foreign exchange Real Ineres rae Expeced inflaion rae NB. All he variables excluding Nominal ineres rae, expeced inflaion rae and real ineres rae are percenages in levels. The remaining variables represen percenage growh raes. 6. Resuls We compare he effecs of exchange rae depreciaion shocks o hose of inflaion shocks on how hey influence real oupu growh raes using VAR sign resricion approach wih 6 lags. We resric shock effecs o las a leas K=6 monhs (see Uhlig (2005); Mallick and Rafiq (2008)). The sabilizaion of oupu, employmen or he real exchange rae is a reason for hiing he inflaion arge a a longer horizon under flexible inflaion argeing (Svensson 1997). Furhermore, he variabiliy of he oupu, employmen and real exchange rae and no heir average levels are imporan. Hence his framework involves less policy acivism and he gradual reurning of he inflaion rae back o he arge rae which reduces he variabiliy of oupu, employmen and real exchange rae. The firs par of he analysis presens resuls based on individual esimaion of shocks following he Uhlig (2005) approach. The second par discuses he resuls based on Mounford and Uhlig (2009) approach which akes orhogonal propery beween fundamenal shocks and impulse responses when wo shocks are esimaed ogeher. We also perform hree robusness ess using he penaly funcion, changing he horizon period in which shocks are expeced o las from K=6 monhs o K=9 monhs and using foreign exchange amoun raher han oal reserves excluding gold. We use growh in nominal exchange rae denoing nominal rand per US dollar changes. We approximae real oupu by manufacuring oupu since i conribued 18% o counry s GDP. -19-

20 Figure 2. Exchange rae shocks NB growh in nominal exchange rae refers o rand per US dollar changes -20-

21 Figure 2 shows he responses o he nominal rand per US dollar, nominal effecive exchange rae and real effecive exchange rae depreciaion shocks respecively. Consisen wih economic heoreical predicions, inflaion responds posiively o currency depreciaion across all measures of exchange raes. These hree differen exchange raes depreciaions significanly increase inflaion rae by a maximum of 0.8 percenage poins in he sevenh monh. Afer 19 monhs, he inflaion increase converges o 0.4 percenage poins which is no significanly differen from zero. Foreign reserves growh remains posiive for 10 monhs exceeding he imposed six monhs (i.e. shock duraion). Granville and Mallick (2010) sugges ha high foreign exchange reserves and high real ineres raes should appreciae domesic currency. However, we do no find significan evidence of he Rand appreciaion in he long run. All hree exchange raes depreciaions have a posiive impac on oupu growh bu his is significan for 8 monhs under he REER depreciaion only. We sugges he volaile currency which fails o self-correc resuling in persisen appreciaions in cerain periods as in figure 1, under inflaion argeing may weaken oupu growh. Moreover, we noice ha he manufacuring growh and oil price inflaion weakened in he long run. This could be due o delayed exchange rae appreciaions afer a depreciaion which erodes he manufacuring compeiiveness whereas persisen inflaion pressures had negaive effecs on real oupu as suggesed by Friedman (1977). I is plausible for oil price inflaion o decline in long-run despie Souh Africa being a small open economy which canno influence world prices. Mishkin (2007) argues ha in he long run he counry which becomes more producive relaive o oher counries expecs is currency o appreciae. Oil price inflaion should decline following such domesic currency appreciaion. -21-

22 The impulse responses beween oupu and reserves show close co-movemens. Concurren declines in reserves and manufacuring could be explained using equaion [2] indicaing ha reserves accumulaion is also driven by developmens in manufacured expors. Thus depreciaion which simulaes growh in manufacured oupu improves he accumulaed foreign reserves. Moreover, foreign reserve accumulaion could resul from physical accumulaion of reserves and monhly revaluaions. Persisen exchange rae appreciaions or depreciaion aler he amoun of reserves in any poin in ime during revaluaion process. The lack of significan evidence of currency appreciaion suggess he dominance of manufacuring expors over exchange rae effecs in influencing reserve accumulaion. The inflaion dynamics in response o an inflaion shock are less persisen compared o hose arising from exchange rae shocks. Granville and Mallick (2010) argue ha he New Keynesian heoreical models do no predic a sufficien degree of inflaion persisence afer a moneary shock. They sugges ha inflaion should rise and recede o zero quickly raher han dying slowly as prediced by empirical lieraure. In addiion, inflaion rises for some exended periods in response o an exchange rae depreciaion and he increase is no significan afer 18 monhs under he NEER and REER depreciaion while i remains persisenly so under nominal rand depreciaion. Figure 3: Inflaion shocks -22-

23 In figure 3, he real ineres raes fall significanly and rerea o pre-shock levels. This suggess ha wih a change in inflaion rae, he nominal ineres rae is changing marginally less han he change in inflaion. Moneary policy conduced in forward looking manner, requires ineres raes smoohing over ime in anicipaion ha inflaion would evenually fall wihin he arge band. In long run, he Fisher effec holds as he change in real ineres rae is no significanly differen from zero. This implies ha he nominal ineres rae increased by he similar change in inflaion rae. We conclude ha moneary policy is effecive in conrolling inflaion over he long horizon. Growh in manufacuring oupu remains significanly posiive for long periods in response o REER depreciaion relaive o boh rand and nominal effecive exchange rae depreciaions. Furhermore, similar o he rand and nominal effecive exchange rae, he resuls sugges ha real effecive exchange rae depreciaion conribue o inflaionary pressures. However, he Cenral Bank increases ineres rae o lower he inflaion rae in he long run. This indicaes ha policies which hugely affec he pricing behaviour o depreciae real effecive exchange rae aimed o improve compeiiveness, have posiive real effecs on oupu growh Resuls from esimaing wo shocks using orhogonaliy assumpion We assess he impacs of he exchange rae and inflaion shocks under he orhogonaliy assumpion o avoid sequenial esimaion and ordering problems. Rafiq and Mallick (2008) argued ha sequenially esimaion procedure may lead o sampling problems suggesing he sequence of shocks would affec he resuls. Hence, we draw he wo vecors simulaneously o eliminae any sampling uncerainy creaed by such sequenially sampling draws. Furhermore, he order in which he shocks are esablished can have implicaions for he final resuls. Our srucural shocks are orhogonally drawn and impulse vecors subsequenly derived which makes he ordering of hese shocks less imporan for he resuls. These resuls are robus o changes in he order of he wo shocks. -23-

24 Figure 4. Comparison of exchange rae depreciaion shocks and inflaion shocks Figure 4 shows he paired effecs of shocks on manufacuring for comparaive purposes. Moreover all impulse responses are presened in Appendix B. These resuls do no differ from hose esimaed using individual shocks. Similarly, he inflaionary shocks have an insignifican simulus on manufacuring growh. In conrary, he real effecive exchange rae leads o significan growh in manufacuring for a leas 7 monhs whereas he rand-dollar and nominal effecive exchange raes have no such effecs on manufacuring oupu growh rae. Thus he previous conclusions are robus o he orhogonaliy and robus o ordering suggesing hese impulse responses do no conain sampling uncerainy creaed by sequenially ordering of he shocks. -24-

25 Variance decomposiion analysis Table 3. Variance decomposiion of all exchange rae shocks and inflaion shocks on manufacuring growh Seps NEER RAND REER INFNEER INFRAND INFREER 1 8.7% 8.9% 10.7% 8.8% 8.7% 8.6% % 10.9% 12.7% 10.9% 11.3% 10.1% % 12.4% 13.6% 11.9% 11.8% 12.1% % 12.5% 14.0% 12.0% 12.1% 12.6% % 13.2% 14.3% 12.5% 12.4% 13.0% % 13.3% 14.8% 12.4% 12.6% 13.2% % 13.4% 14.9% 12.5% 12.9% 13.4% % 13.5% 15.0% 12.6% 13.4% 13.5% % 13.8% 15.2% 12.6% 13.5% 13.6% % 14.1% 15.3% 12.7% 13.6% 13.7% % 14.3% 15.3% 13.0% 13.7% 14.0% % 14.7% 15.5% 13.2% 13.8% 14.2% % 15.1% 15.6% 13.3% 14.3% 14.3% % 15.2% 15.6% 13.6% 14.5% 14.5% % 15.7% 15.4% 13.8% 14.7% 14.7% % 15.7% 15.4% 13.9% 14.8% 14.8% % 15.9% 15.4% 14.0% 14.9% 15.0% % 15.9% 15.5% 14.2% 14.9% 15.1% % 16.0% 15.6% 14.5% 14.9% 15.2% % 16.0% 15.7% 14.6% 15.0% 15.1% % 15.9% 15.7% 14.7% 15.1% 15.2% % 15.9% 15.8% 14.8% 15.2% 15.2% % 16.0% 15.7% 14.8% 15.2% 15.2% % 16.0% 15.7% 14.8% 15.2% 15.4% NB Inflneer, inflrand and inflreer refers o inflaion shocks esimaed using nominal effecive exchange rae (NEER), rand dollar exchange rae and real effecive exchange rae (REER). Seps ahead refers o horizons in monhs. Table 3 shows he variance decomposiions of differen exchange rae shocks and he various inflaion shocks esimaed under hree exchange raes. The variance explained by inflaion shocks is lower han he corresponding variabiliy explained by exchange rae shocks over all horizons. Amongs hese hree exchange raes, real effecive exchange rae (REER) induces more variabiliy in manufacured oupu in 14 monhs relaive o rand exchange raes and 17 monhs relaive o NEER. Moreover, he REER long run values are lower han oher exchange rae long run values Robusness analysis This secion examines robusness of he earlier findings using penaly funcion, changing horizons for which shocks are expeced o las and using foreign exchange under orhogonaliy assumpions. Figure 5 shows manufacuring impulse responses from he penaly funcion -25-