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1 thank Trevor Alleyne, Torbjörn Becker, David Coe, Jose Fajgenbaum, Zenon Kontolemis, Jean-Claude Nachega, Eric Schalling, Arvind Subramanian, Yougesh Khatri, Krishna Srinivasan, Tarik Yousef, and seminar participants at IMF’s African Department and the University of Cape Town for discussions and comments. The usual disclaimer applies.
Strictly speaking, an unstable relationship between money growth and inflation does not necessarily imply that money demand is unstable, as the latter would be expected to vary with fluctuations in other variables, such as real income and nominal interest rates.
The Reserve Bank has announced annual guidelines for growth in broad money since 1986 (6-10 percent in 1997). However, actual growth in M3 has substantially exceeded the guideline range during the last few years, and the authorities have on several occasions announced that the Reserve Bank in practice is guided by developments in a number of different indicators, including various price indices, the shape of the yield curve, the nominal exchange rate, and the output gap (see South African Reserve Bank (1998)).
For example, the sum of merchandise exports and imports remained at about 35 percent of GDP during the sanctions period 1985-95, although the financial sanctions forced South Africa to shift from running external current account deficits in the early 1980s to current account surpluses from 1985 to the early 1990s; see, e.g., Jonsson and Subramanian (1999) and Lipton (1998) for discussions. The authorities also operated a dual exchange rate system and had extensive capital controls in place during long periods up to 1995, with financial transactions typically being traded at a discounted exchange rate (the financial rand mechanism); see Garner (1994) for a description of this system. In the current paper, the market determined exchange rate for the commercial rand is used throughout the study, see Appendix for details.
Johansen and Juselius (1990), Hendry and Ericsson (1991), and Ericsson (1998) are examples of useful studies that discuss a range of econometric and time-series issues that arises in studies of money demand. McDonald (1995), Rogoff (1996), Nessen (1996) and Habermeier and Mesquita (1999) are examples of studies that survey the PPP literature and provide some new results using cointegration methods.
Earlier money demand studies for South Africa include Courakis (1984), Whittaker (1985), Tavlas (1989), and Hum (1991). However, as pointed out by Hum and Muscatelli (1992), these studies do not consistently estimate the long-run elasticities of the variables in the money demand function.
More precisely, economic theory suggests that demand for money depends on the opportunity cost of holding money. Although the opportunity cost for holding cash is larger when the nominal interest rate is higher, it is ambiguous whether broader definitions of money are positively or negatively related to the nominal interest rate, as broader money typically is interest bearing. See Section III. A for further discussion.
Visual inspection suggests that a time trend arguably should be included in the first difference test for q. Allowing for such a trend indicates that also this series is integrated of order 1. Moreover, the foreign price series adjusted for the effective exchange rate is clearly integrated of order 1.
Foreign prices could arguably a priori be treated as an exogenous variable. Indeed, as shown below, the empirical results reveal that foreign prices do not respond to deviations from any of the estimated long-run relationships.
The number of cointegrating vectors were estimated using both the maximum eigenvalue statistic and the trace statistic (allowing for unrestricted intercepts but no trends), with the significance level set to 5 percent.
A time dummy for the period 1994:1-1998:2 and seasonal dummies were included in the model as well. The time dummy was included without restricting it to the cointegrating vector, implying that the average growth rates of the variables can change at the time of the structural change, while the cointegrating vectors remain unchanged.
By not constraining the coefficients on q and e to equal 1 (in absolute values), the test allows for various fixed costs, such as transportation and menu costs, to vary over time and across countries. This test is sometimes referred to as a simple test of PPP.
In fact, Podivinsky (1998) shows that it is preferable to overspecify the number of variables in the model and later add exclusion restrictions, rather than underspecifying the model, as the latter has low power in detecting the true number of cointegrating vectors.
The restricted cointegrated vectors in Figure 2 are given by the fourth specification in the lower part of Table 4, i.e., CV-ppp = [p + 0.88*e -1.28*prow] and CV-md = [p - m3 + 1.22*y - 0.04*i-long + 0.02*i-short]
The recursive estimations occasionally failed to converge due to the sharp reductions in the number of observations. Hence, these estimations were done under the assumption of two (rather than three) cointegrating relationships, and without constraining the coefficient on m. 3 to -1. Despite this, the estimated coefficient on m3 was always relatively close to -1; the fact that it was not constrained to this value implies that the recursively estimated coefficient on y is a somewhat (upward) biased estimate of the income elasticity.
As discussed in Section II.B, the coefficients in the α matrix capture the speed of adjustment of a particular variable to a deviation from the long-run equilibria; thus, a zero restriction on any coefficient in this matrix correspond to the null hypothesis that the particular variable does not adjust to restore the long-run equilibrium, and therefore can be treated as weakly exogenous.
The absence of weak exogeneity for a subset of variables implies that it is not appropriate to model a particular variable, such as inflation, in a one-equation error-correcting (parsimonious) model.
Except for the interest rates, where the dependent variable is the change in the interest rate.
As a comparison, McDonald (1995) finds that the average speed of the nominal exchange rate adjustment following a deviation from PPP is about 2 percent per month for a set of bilateral U.S. dollar exchange rates, implying a half-life of a shock to PPP of about 36 months.
The practical significance of the ordering is that a shock to a variable is allowed to have contemporaneous effects only on the variable itself and the succeeding variables in the ordering. Thus, the assumed ordering implies that a shock to, for example, real output may have a contemporaneous effect on the nominal variables m3, p, e, and i, while a shock to any of these nominal variables can only affect real output with (at least) a one quarter lag.
A shift in the monetary policy regime took place in the early 1980s; the Reserve Bank moved to a system of indirect control of money supply and adjustments of short-term interest rates, rather than changes in cash and liquid asset requirements combined with credit ceilings and interest rate controls. This probably enhanced the responsiveness of monetary aggregates to macroeconomic developments.