DeJager, C.J. and R. Ehlers (1997), “The relationship between South African monetary aggregates, interest rates and inflation—a statistical investigation”, Departmental memorandum, Economics Department, South African Reserve Bank.
Hum, A.S. (1991), “Interest rates, inflation and the stability of the demand for M3 in South Africa”, Greek Economic Review, 13, 251–268.
All data series are from the South African Reserve Bank, Quarterly Bulletin, except for the U.S. interest rates which are taken from IMF, International Financial Statistics. The following variables are included in the study:
CPIu: Underlying consumer price index. This index equals total CPI excluding “food and nonalcoholic beverages”, “home owner’s cost” and “value added tax”.
NC: Notes and coin outside the banking system.
Ml: NC plus checking deposits.
M2: Ml plus short- and medium-term deposits.
M3: M2 plus long-term deposits.
PSC: Credit extension to the private sector.
3m: Interest rate on 3-months t-bill.
10y: Interest rate on 10-year government bonds.
3mS: Spread between interest rates on 3-months t-bills in South Africa and the U.S.
10yS: Spread between interest rates on 10-year bonds in South Africa and the U.S.
US$: Nominal exchange rate; Rand per US dollar.
NEER or E: Nominal effective exchange rate including (weights in brackets) U.S. dollar (51.7), British pound (20.2), Deutsche mark (17.2), and Japanese yen (10.9).
P*: Effective producer price index in foreign countries, including the same four countries and weights as when calculating the NEER.
Wage: Remuneration per worker in the nonagricultural sectors.
ULC: Unit labor costs in the nonagricultural sectors.
GDP: Real gross domestic product, 1990 prices, seasonally adjusted.
Gap: Output gap; calculated by using the Hodrick-Prescott filter (with λ=400) on real GDP.
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.
The Reserve Bank’s measurement of the nominal effective exchange rate is used throughout the paper; an increase in the effective exchange rate means an appreciation of the rand. See Appendix for details.
An inflation target regime basically involves a two-step approach: First, the authorities project the future inflation rate under current policies by studying indicators such as current and past values of money growth, interest rates, exchange rates, and output activity. Together, these “leading indicators” are used to evaluate the inflation-momentum in the economy which is compared with the inflation target. Second, if projected inflation is outside the target, the authorities pursue an appropriate policy mix using available instruments to correct for the discrepancy. The empirical analysis in this paper is related to the first of these steps, i.e., it can be regarded as a preliminary attempt to find useful leading indicators of inflation.
It should be noted that the “Granger-causality” concept has a different interpretation from what is usually meant by causation. The intuition behind Granger-causality is simply that if an event y is the cause of an event x, then y must precede x in time, and by using past observations of y in addition to past observations of x, the forecast of x should improve.
As is conventional in the literature, all variables are expressed in natural logarithms, except for the nominal interest rate. Hence, the first difference of a variable equals the percentage change from the previous quarter.
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. Ideally, one should control for any differences between the “own” deposit interest rate and the interest rate on alternative assets (such as government securities). See Ericsson (1998) for further discussions.
The dummy was included in the model 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.
The Granger-causality tests should be interpreted with particular caution when (long-term) interest rates are used as an indicator. It is well-known that aggregates which reflect forward-looking behavior often are good predictors of various macroeconomic time series. Obviously, this does not mean that these variables “cause” fluctuations in other variables; it rather reflects that the market uses current information efficiently.
The same tests were performed using inflation rather than underlying inflation. The results (not reported) were similar to those in Table 4, although foreign prices and wages seemed to contain less predictive information about future inflation than for underlying inflation, whereas the opposite was true for M3.
If the output gap is due to a positive aggregate supply shock, one could expect a (temporary) fall in inflation, whereas the opposite would be true when the output gap is the result of a shock to aggregate demand.
Both the Akaike Information Criterion and the Schwarz Bayesian Criterion were examined.
By not constraining the coefficients 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.
The error-correction terms were derived from the restricted VAR model which included M3, and interest rates on government bonds (each with 3 lags), with the coefficients on prices and M3 constrained to -1 and 1, respectively.