The transmission mechanism of monetary policy in South Africa

Abstract

Executive summary by author:

In this thesis, Chapter 1 provides a theoretical literature survey of the different channels of monetary transmission with specific reference to the South African economy. The literature finds that the monetary policy can affect economic variables through different mechanisms. In the survey, it becomes clear that in order to conduct monetary policy successfully, monetary authorities need to isolate what are the relevant transmission mechanisms in the economy. The different transmission mechanisms have different implications on how monetary policy can stabilise output and inflation. In addition, it transpired that the different channels of monetary transmission raise a variety of empirical and policy questions about the modalities of monetary theory and policy that need to be empirically tested. The key question is how do macroeconomic variables (especially output and the price level) respond to changes in the interest rate (monetary policy instrument)?

Against this background, in Chapter 2, the empirical questions raised by the monetary transmission mechanism are formally tested by means of modern econometric techniques. The main technique used to uncover the monetary transmission is Vector Auto Regression (VAR). The basic VAR model is modified into a Vector Error Correction Model (VECM) that incorporates long run structural relationships, suggested by economic theory. We adopt a modelling strategy that follows a subsystem approach in which a subset of random variables will be regarded as structurally exogenous. This strategy is particularly useful in the context of a small open economy such as South Africa where in the long run domestic variables are not expected to have any feedback effects into foreign variables (oil prices and foreign interest rates). The dynamic interaction amongst macroeconomic variables of the model is mainly drawn from the results of the Impulse Response Functions (IRF) and the Forecast Error Variance Decomposition (FEVD). The study uses monthly data for period 1983-2001. One of the main findings of this study was that an unexpected increase in the monetary policy instrument (nominal interest rate) leads to a significant decline in the price level and money supply (in the short run) and an appreciation of the exchange rate. These results are in conformity with the economic theory of transmission mechanism of monetary policy. It was also found that monetary policy (via nominal interest rate) plays an important role in output determination only indirectly through the effective exchange rate but no significant role directly via conventional interest rate channel. The study further established that monetary policy shock leads to an appreciation of the local exchange rate. However, an increase in the nominal interest rate following devaluation does not succeed in subsequently increasing the exchange rate. This would imply that monetary policy in South Africa is ineffective in rescuing currency devaluation (depreciation). The study further found that the interest rate channel does not operate smoothly via the credit market and no statistically significant evidence could also be found for the existence of a potent (having impact on output and prices) direct credit channel in South Africa. This implies that no statistical evidence could be found for the existence of an indirect or direct credit channel in South Africa. Finally, the main result from the FEVD implies that the monetary policy instrument seems to be fairly exogenous in South Africa, mainly reflecting exogenous policy changes by the Central Bank