The external current account in South Africa has strengthened significantly in 1999, mainly owing to a large decline in imports. Compared with a deficit of about 1.5 percent of GDP in recent years, it is close to balance during the first three quarters of 1999. A resumption of investor confidence has led to an increase in international reserves and facilitated a decline in the net open forward position (NOFP). The external current account deficit has declined to 0.2 percent of GDP during the first three quarters of 1999.


The external current account in South Africa has strengthened significantly in 1999, mainly owing to a large decline in imports. Compared with a deficit of about 1.5 percent of GDP in recent years, it is close to balance during the first three quarters of 1999. A resumption of investor confidence has led to an increase in international reserves and facilitated a decline in the net open forward position (NOFP). The external current account deficit has declined to 0.2 percent of GDP during the first three quarters of 1999.

VI. Inflation Targeting as a Monetary Policy Framework in South Africa 100

187. A number of industrial countries have adopted a framework for monetary policy that became known as inflation targeting in the 1990s.101 In most cases, inflation targeting was introduced after unsuccessful attempts to target some monetary aggregate (e.g., Canada) or the nominal exchange rate (e.g., United Kingdom and Sweden). Its increasing popularity also has been nourished by a growing consensus among policymakers, economists, and the public in general that there is no long-term trade-off between inflation and output, and that price stability fosters economic growth. For similar reasons, several emerging market economies have recently adopted, or indicated that they intend to adopt, inflation targeting as their monetary policy framework.102

188. In South Africa, the general monetary policy objective is “to protect the value of the rand.”103 The South African Reserve Bank (SARB) attempts to achieve this objective by gradually bringing core inflation104 down to the level prevailing in South Africa’s major trading partners over the medium term.105 Given this goal, the SARB has opted for an eclectic approach to monetary policy, which is based on informal guidelines for growth in broad money and bank credit extension, supplemented by the monitoring of a range of economic and financial indicators.

189. More recently, Governor Mboweni of the SARB has argued that South Africa should “move away from the ‘eclectic’ or informal inflation-targeting framework to formal inflation targeting,”106 and the Minister of Finance, Mr. Manuel, has indicated that a formal inflation targeting framework will be announced and implemented during 2000. The purpose of this section is to examine the implications of the adoption of a formal inflation-targeting framework in South Africa. Subsection A briefly describes the main elements of inflation targeting. Subsection B assesses whether South Africa complies with the institutional and macroeconomic prerequisites for inflation targeting, while Subsection C discusses the relative merits and consequences of adopting inflation targeting in South Africa. Subsection D highlights some specific features of the South African economy, which may be of particular importance when considering an inflation targeting framework. Subsection E concludes and presents some issues for further discussion.

A. Inflation Targeting: General Features

190. The main feature of an inflation-targeting framework is that the central bank adopts or is given a clear mandate to concentrate on achieving an explicit inflation target as the overriding objective of monetary policy. The basic ingredients of inflation targeting include the announcement of a target for future inflation at some low level or range; periodic assessments of expected inflation over the relevant horizon on the basis of a set of variables; and systematic adjustments of the monetary policy instruments to maintain the projected inflation rate in line with the target.107

191. As implemented in practice, inflation targeting is characterized as a fairly broad framework for the conduct of monetary policy rather than a specific policy rule. Indeed, inflation-targeting central banks maintain significant scope for applying discretion in the conduct of monetary policy, as the inflation targets typically need to be attained over a multiyear horizon and are in many cases specified in terms of bands rather than point estimates.

192. Another important element in an inflation-targeting framework is a relatively high degree of transparency of monetary policy and accountability of the central bank. All inflation-targeting central banks have intensified their efforts to communicate and clarify to the public the goals of monetary policy, describe and justify the policy measures being taken to achieve these goals, and explain the recent performance of monetary policy, always with a focus on future inflation as the fundamental objective of the actions of the central bank. A number of vehicles have been used for greater transparency, including regular publications of extensive inflation reports, appearances of central bank officials before parliamentary committees, and published minutes of monetary policy council meetings.

193. The inflation target also provides a yardstick against which the central banks’ actions can be evaluated, and, with the enhanced transparency associated with inflation targeting, the central banks have naturally become more accountable about their actions in the public debate and the political process.

B. The Feasibility of Inflation Targeting in South Africa

194. The prerequisites needed to adopt an inflation-targeting framework for monetary policy include institutional aspects, such as an absence of commitments to objectives that might conflict with low inflation; an independent central bank, at least operationally; sufficiently developed capital and money markets; and a reasonable degree of control and forecastability of the inflation process. In general, South Africa satisfies these conditions.

Institutional aspects

195. In an inflation-targeting regime, the paramount goal of monetary policy is achieving the inflation target. Any other goal can be pursued only to the extent that it is consistent with the inflation target. The conduct of monetary policy cannot be subordinated to fiscal needs, such as reliance on revenue from seigniorage or a need to provide central bank financing to the government, nor can monetary policy be used to ultimately target the exchange rate or any other nominal variable. In South Africa’s case, there is no fiscal dominance of monetary policy, nor is there a commitment to target the nominal exchange rate or other nominal variables with monetary policy.

196. The central bank must be capable of pursuing the inflation goal free of constraints on its use of monetary policy instruments. This does not necessarily mean it must be free to set its own goals (goal independence), but it must be free to use the monetary policy instruments at its disposal in the pursuit of the inflation goal (instrument independence). Actual monetary policy decisions are typically taken by a Monetary Policy Committee of the central bank or by the central bank board. In all inflation-targeting countries, the central banks have instrument independence, but the process of setting the inflation target varies across countries. In South Africa, the SARB has constitutionally granted goal and instrument independence, and it is free to unilaterally announce a move to inflation targeting if it so desires. The fact that the Ministry of Finance also supports the move to inflation targeting is an additional advantage.

197. A reasonably well-developed financial market facilitates the operations of an inflation-targeting framework. Policy instruments need to be effective in influencing the economy, while money and capital markets must be sufficiently developed so as to react quickly to the use of these instruments. South Africa has quite sophisticated financial markets, and monetary policy changes tend to influence the money market interest rates in a transparent and rapid fashion. The SARB’s repurchase system, together with other open market operations for managing liquidity, constitute an appropriate framework for effective monetary policy operations.

Macroeconomic aspects

198. To control inflation (under any monetary policy framework), there must be a reasonably stable relationship between the monetary policy instruments and inflation outcomes. In an inflation-targeting framework, inflation must also be forecastable to a reasonable degree. Given the forward-looking nature of the inflation target, changes in monetary policy have to be made on the basis of forecasted changes in inflation. This requires that the authorities be able to develop a satisfactory forecasting framework.

199. While South Africa has undergone a degree of structural change in recent years, inflation appears to be relatively well behaved and forecastable. The SARB regularly undertakes and revises its inflation projections using models that are based on a range of financial and economic variables, including a set of leading indicators of inflation (see, e.g., Pretorius (1997)). Further refinement and strengthening of the SARB’s forecasting framework would help improve the accuracy of the inflation projections, which is critical in an inflation-targeting regime. Moreover, it is possible that some further experience with the repurchase system (which was introduced in March 1998), including how changes in the repurchase rate feed into the inflation forecasts, is needed before a full-fledged inflation- targeting framework is introduced.108

200. Notwithstanding these considerations, it can be noted that many financial and macroeconomic aggregates in South Africa tend to interact in a similar way as in many other more developed economies. In an empirical analysis of the relationship between inflation and a set of financial and macroeconomic aggregates in Fajgenbaum and others (1998), it was argued that a number of reasonable leading indicators for inflation could be identified. It was also argued that, despite the structural shifts in the economy, there exists a stable money demand type of relationship involving domestic prices, broad money, real income, and nominal interest rates, with plausible estimates of the long-run coefficients, as well as a long- run relationship among domestic prices, foreign prices, and the nominal effective exchange rate.109

201. Moreover, an extension of that study—described in Appendix I—shows that the variables tend to adjust and interact in the short run in a way that is similar to that typically found in developed economies. In particular, it is found that a shock to the nominal exchange rate has an almost immediate impact on domestic prices, while shocks to either money or output affect domestic prices with a lag of four-six quarters. It is also found that a monetary shock has a temporary impact on real output before inflation picks up. These results are similar to those found in a number of other countries. For example, Sims (1992) uses a similar vector autoregression (VAR) approach to study the effects of monetary policy in five OECD countries; he shows that a shock to the money equation results in a temporary real output response in France, United Kingdom, and the United States, while prices adjust with a lag. He also shows that a positive shock to real output exerts upward pressure on domestic prices with a lag of several quarters in most countries. Together, these results suggest that it would be possible to develop a forecasting model for inflation in South Africa that is similar to those used in other countries that have implemented inflation targeting.

C. Relative Merits and Implications of Inflation Targeting in South Africa

202. The main advantage of adopting an inflation-targeting framework in South Africa would be to raise the likelihood of attaining and maintaining a low and stable rate of inflation, with concomitant beneficial effects on economic growth.110 An inflation-targeting framework could help the SARB resist pressures to conduct expansionary monetary policies inspired by short-term considerations, as it would help in focusing the attention of economic agents, politicians, the press, and the public on the long-term objectives and consequences of monetary policy. Moreover, the explicit mandate of the SARB to achieve low inflation, together with the increased transparency of monetary policy and accountability, would tend to reduce uncertainties among price- and wage-setters about the future path of the inflation rate, and thereby contribute to more coordinated and accurate inflation expectations.

203. A second advantage of an inflation-targeting framework (compared with a framework based strictly on monetary or exchange rate targeting) is that, if judiciously implemented, it could lead to a better cyclical adjustment of the economy. This is because an inflation- targeting framework provides substantial scope for applying discretion in the conduct of monetary policy, and thus provides the central bank with flexibility to deal with aggregate demand and supply shocks, while a target for the exchange rate or some monetary aggregate generally implies more rigidity in this regard.111

204. An inflation-targeting framework, however, provides no guarantee that the central bank will use its discretion appropriately in formulating monetary policy. For instance, the central bank might interpret its mandate too strictly and attempt to target “headline” inflation over a relatively short time horizon, which can lead to excessive instability in other macroeconomic variables, such as output, interest rates, and the exchange rate. In this context, a potential concern is that in a small, open economy that is prone to external shocks, inflation targeting could generate large fluctuations in the real exchange rate with concomitant fluctuations in the external current account balance. However, these fluctuations could be accommodated either by introducing well-designed “escape clauses” or by establishing a sufficiently wide band around the inflation target (see below). Moreover, the simplest theoretical model of inflation targeting indicates that the “credibility versus flexibility” trade-off can be avoided by adopting an appropriately defined inflation target. This means that the average rate of inflation could be reduced without resulting in higher output volatility (see Appendix II for a more detailed discussion). In addition, empirical evidence from countries that have implemented inflation targeting tends to support this argument (see, e.g., Mishkin (1999), Jonsson (1999a), and Sarel (1999)).

205. As with any monetary policy framework, the introduction of inflation targeting involves the risk that an initial disinflation process could result in short-term output costs if the public does not quickly find the policy credible. Of course, these costs will tend to be lower the more effective the SARB is in explaining its objective and the necessary policies to achieve it, the better the public understands the rationale for adopting inflation targeting, and the more explicit the government is in endorsing the inflation targeting regime. Also, adjustments of inflation expectations would be facilitated if the targeted path for the decline in inflation was perceived as realistic. To address these issues, the SARB has set up a Monetary Policy Committee, which meets every six weeks to assess policy and operational issues, and a summary of its deliberations is being made public. In addition, the Governor of the SARB has indicated that he will consult with civil society, including business and labor representatives, before introducing inflation targeting, so as to enable all parties to become familiar with the new framework.

206. While it can be argued that the SARB has been implementing an informal inflation- targeting framework, and that a move to a formal inflation-targeting framework would not change the actual conduct of monetary policy in a significant way, it is likely that the absence of an explicit and well-defined target for monetary policy has created some uncertainties among economic agents about the SARB’s objectives. These uncertainties might have been reinforced by the observations that the growth rates in broad money and credit extension have exceeded their indicative guidelines in recent years,112 and by the occasionally heavy intervention by the SARB in the spot and forward foreign exchange markets. Thus, to the extent that a formal or explicit inflation-targeting framework would be perceived as a stronger commitment to reduce inflation over the medium term and bring more clarity to the conduct of the SARB’s monetary policy operations, some of these uncertainties would be eased. This would, in turn, improve the accuracy and coordination of inflation expectations, and possibly reduce the risk premium on investment in South Africa, implying a lower path for long-term interest rates.

207. Hence, an important implication and advantage of the adoption of a formal inflation targeting regime in South Africa would be the associated enhancement of both the transparency of monetary policy and the accountability of the SARB. This enhancement would take the form of frequent public disclosures of the SARB’s inflation projections and associated monetary policy measures by, for example, regular publications of inflation reports and the release of more general economic forecasts, as well as regular testimony to parliament. Moreover, the adoption of explicit targets for monetary policy and the accountability that this involves would impose a natural discipline upon the SARB, which, in turn, would help bolster its credibility.

208. Moreover, in the event of a breach of the inflation target (which occasionally can be expected because of the lags involved in the monetary transmission mechanism), the increased transparency of monetary policy and accountability of the SARB should, to some extent, make apparent whether such a breach is caused by a failure to respond to inflationary pressures, whether it was foreseeable at the time of the policy decision, or whether it reflects shocks outside the control of the SARB.

D. Specific Concerns in South Africa

209. In assessing whether inflation targeting is a feasible and desirable framework for South Africa, three additional questions need to be answered. First, does the fact that South Africa is an emerging-market economy, with the associated risk for large swings in capital flows and the exchange rate, pose any particular problems for inflation targeting? Second, how does the presence of potentially divergent views on what constitutes an appropriate monetary policy stance across business and labor representatives, the government, and the SARB affect the feasibility and desirability of inflation targeting? Third, is the SARB’s goal of reducing its large open foreign exchange position in the forward market consistent with an inflation-targeting framework?

Inflation targeting in an emerging market economy

210. As noted in the introduction, the Czech Republic and Brazil have recently implemented a full-fledged inflation-targeting framework, and other emerging market economies may follow in the near future. One important feature of the emerging markets in recent years, including South Africa, has been the very large and volatile capital flows and associated swings in the nominal exchange rate. How do these issues affect the feasibility and desirability of inflation targeting?

211. Three aspects deserve to be mentioned. First, it is possible that inflation targeting could, to some extent, actually dampen the volatility in the capital flows and the associated sharp swings in the nominal exchange rate. In many emerging-market economies, the currency has been attacked precisely because the central banks have had an implicit or explicit exchange rate objective that was not perceived as credible (e.g., Mexico in 1994 and Brazil in 1998/99). In South Africa, some of the volatility in the foreign exchange markets may have been driven by uncertainties about the SARB’s objectives regarding the exchange rate. Consequently, to the extent that the adoption of inflation targeting signals a clear commitment to a flexible exchange rate regime, such a framework should contribute to more stable foreign exchange and capital market conditions.

212. Second, in the case of South Africa, it is interesting to note that despite the large and volatile capital and exchange rate movements during the 1990s, fluctuations in inflation have been relatively limited, especially with respect to core inflation. In particular, while large capital outflows in 1994,1996, and 1998 caused the nominal exchange rate to depreciate substantially, the impact on (core) inflation was modest.113 Although this pattern possibly is associated with a contemporaneous movement in economic activity, it seems that the SARB has been successful in controlling the inflationary impulses generated by the volatile capital flows.

213. Third, as discussed above, an inflation-targeting regime allows for certain fluctuations in the actual inflation rate, especially if the inflation target is set in terms of a band rather than a point. Of course, to be meaningful, the width of a band would have to be limited, although the possibility of volatile capital flows may argue in favor of adopting a band around the inflation target that is somewhat wider than the common ± 1 percentage point.114

Inflation targeting and divergent views on monetary policy

214. In the economic literature (and in the South African press) it has been debated whether the central bank or the government should set the inflation target, that is, whether the central bank should have goal or instrument independence. In this context, a more general question is whether it is necessary to form a broad consensus about the appropriate monetary policy among not only the central bank and the government, but also the business community, the labor organizations, etc., before inflation targeting is implemented.

215. To start with, and as discussed above, it can be noted that inflation-targeting economies differ on the issue of goal versus instrument independence for the central bank (see Jonsson (1999a)). The features of the labor market and various political institutions (such as the degree of trade unionization, wage-bargaining system, political ideology of the government, etc.) also vary substantially across the inflation-targeting countries. Moreover, it is unclear whether there ever was a general consensus among the various interest groups about monetary policy when inflation-targeting was introduced in these countries. However, despite these differences, the macroeconomic outcomes under inflation targeting seem to be quite similar across the countries that have adopted this framework.

216. Although the South African authorities managed to reduce inflation at a relatively steady pace during the 1990s without any formal or apparent consensus among the various interest groups in the economy, it is important to emphasize that a formal inflation-targeting framework would be more effective when economic policies are well coordinated.115 If this is not the case, the disinflation process and adjustments to adverse shocks will generate higher short-term output costs, at least until credibility is established. Similarly, structural policies will also play an important role in determining the cost associated with achieving and maintaining a lower inflation rate—a flexible labor market will help lower the output costs, as wage increases would adjust to lower inflation and aggregate shocks, while competitive product markets can help spread the benefits of lower inflation more rapidly. Because of these arguments, the Governor has argued that the inflation target should be set jointly by the Reserve Bank and the government, that the coordination of policies should be clearly spelled out, and that all stakeholders must be consulted, including business and the trade union movement (see South African Reserve Bank (1999c)).

Inflation targeting and the foreign exchange position of the SARB

217. By international standards, South Africa’s level of international reserves is quite low; at the same time, the SARB has large outstanding forward foreign exchange liabilities. In response, the SARB gradually reduced these liabilities and increased its international reserves during 1999, and announced that it intends to continue this process.116 In this context, a question often raised is whether these objectives are consistent with the implementation of an inflation-targeting regime.

218. In principle, a gradual reduction of the forward position and/or a buildup of reserves are compatible with inflation targeting. The reason is that the SARB can achieve its objectives with regard to international reserves (spot and forward) by operations in the foreign exchange markets (i.e., purchases and sales of foreign exchange) and then assess whether, and to what extent, these operations affect variables that are important in the inflation-forecasting framework (such as the nominal exchange rate). Given this information, the SARB would adjust its interest rate instrument accordingly, in order to achieve the inflation objective.

219. In this context, it is interesting to note that Sweden had an open forward foreign exchange position of about US$22 billion when the Riksbank introduced an inflation targeting regime in January 1993. Sweden has achieved price stability since then, and the net forward position of the Riksbank was virtually eliminated over the course of the next four years.

E. Conclusion and Discussion

220. This paper suggests that a monetary policy framework based on inflation targeting could represent an improvement over the current policy framework in South Africa, as it would help clarify the monetary policy objectives of the SARB, enhance the transparency of its operations, and strengthen the SARB’s accountability. This could contribute to more accurate and coordinated inflation expectations which, in turn, would help in reducing output volatility, and improving the long-term outlook for growth and development. It is important to keep in mind, however, that in practice the success of inflation targeting depends on the specific manner in which it is conducted.

221. South Africa satisfies the main prerequisites for adopting an inflation-targeting regime, including an absence of commitments to macroeconomic objectives that might conflict with low inflation, an independent central bank, and relatively developed capital and money markets. Nevertheless, some additional preparatory work may need to be undertaken before inflation targeting can be effectively introduced, including further experience with, and analysis of, the operational aspects of the repurchase system and a refinement of the SARB’s inflation-forecasting framework.

222. Moreover, a number of largely technical issues will need to be addressed, including, for example, which measure of inflation should be targeted, what its initial level should be, and what would be its subsequent time path. These issues are beyond the scope of this section, but it can be noted that some inflation-targeting countries have specified the inflation target in terms of a headline consumer price index (CPI), while other countries have established targets based on some form of “underlying” or core inflation measure. The advantage with targeting headline CPI is that it is usually widely accepted and well publicized, while a main disadvantage is that it can be quite volatile and move perversely (in the short run) in response to monetary policy changes. For example, when mortgage interest charges are included in the CPI measure (as is the case in South Africa), a tightening of monetary policy could have the effect of raising measured inflation as the higher cost of funds leads to higher mortgage costs. However, the choice of price index may not be very important in determining the appropriate level of short-term interest rates. The reason is that, under an inflation-targeting framework, monetary (or interest rate) policy is guided by the difference between the inflation target and projected inflation, and, although the current rate of inflation may vary with different measures of inflation, the projected rate of inflation in, say, two years, is likely to be quite similar. For example, the difference between headline and core inflation in South Africa was unprecedently high at 6.3 percentage points in October 1999 (headline inflation was 1.7 percent, while core inflation was 8 percent). Notwithstanding this very large gap, the difference in the two-year-ahead median forecasts for headline and core inflation among 21 analysts/forecasters was only 0.4 percentage point in December 1999.117

223. The initial level of, and subsequent path for, the inflation targets in South Africa would in part depend on the prevailing rate of inflation at the time of introduction of the new framework. In some countries, where inflation was significantly higher than the ultimate target, a prespecified timetable of gradual disinflation was adopted.118 Given that any long- run inflation target for South Africa would likely be close to the inflation rate in its major trading partners, and that the actual inflation rate in the near future might exceed this rate, the adoption of a gradual disinflation process seems sensible. The period over which such a disinflation might occur and the width of any band adopted during such a process are clearly matters for further consideration.

Appendix I: Short-Run Comovements Among Variables Important for Inflation in South Africa

224. The results of an empirical study presented in last year’s Selected Issues paper (SM/98/164), (see Fajgenbaum and others (1998)) show that, in the long run, demand for broad money tends to be stable, with plausible coefficients on the estimated parameters; at the same time, the purchasing power parity (PPP) hypothesis cannot be rejected. However, to draw policy conclusions, the issues of which variables should be treated as exogenous or endogenous and how they interact in the short run become important. Moreover, in an inflation-targeting framework, it would be useful to understand how the economy adjusts toward the long-run equilibria—here described by the money demand and PPP relationships—following various types of shocks. These issues are discussed in this appendix.119

225. The main results are that, in the event of a disequilibrium, both domestic prices and the nominal exchange rate adjust to restore PPP, while the short-term interest rate and broad money adjust to restore equilibrium in the money markets. Moreover, shocks to the nominal exchange rate affect domestic prices with a short lag but have a limited impact on real output, while shocks to broad money have a temporary impact on real output before domestic prices adjust.

226. The exogeneity issue was addressed by adding exclusion restrictions on the or matrix in the vector error-correction model120


where x is the vector of variables in the system comprising domestic prices (p), broad money (m3), real income (y), interest rates (i), foreign prices (q), and the nominal exchange rate (e)—and the matrix π can be written as π = αβ’, with β containing the r cointegrating vectors and α describing the speed of adjustments to the long-run equilibria (the error- correcting terms).121 A zero restriction on any coefficient in the a matrix corresponds 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.

227. As expected, the results indicate that foreign prices are clearly exogenous (see Table 23): foreign prices do not adjust to any disequlibria in the South African markets. In the PPP relationship, both domestic prices and the nominal exchange rate should be treated as endogenous, as both variables tend to adjust following deviations from the PPP equilibrium. In contrast, in the money demand relationship, domestic prices (together with real income and long-term interest rates) could be treated as weakly exogenous, as the adjustment following a deviation from the estimated long-run equilibrium in the money market seems to come through the short-term interest rate and, to some extent, through a change in money holdings.122

228. As a complement to the above results, the short-run comovements among the variables were examined by generating orthogonalized impulse response functions based on equation (1), while allowing for the two long-run restrictions on the ft matrix representing the money demand and PPP relationships (see the top panel of Table 23). This approach allows the investigation of the impact of different types of shocks on both the variables in the model and the estimated equilibrium relationships. In addition, the impulse response functions give an indication of the lag structure in the economy, which could be useful from an inflation- forecasting perspective. Thus, the main focus was on the inflationary impact of shocks to the money, exchange rate, price, and output equations, respectively. Impulse response functions were generated with an eight-year horizon (32 quarters), and each innovation was obtained by a standard Choleski decomposition, where the ordering of the variables in general matters. The somewhat arbitrarily chosen ordering was q, y, m3, p, e, i-short, and i-long.123

229. The results are illustrated in Figures 15 and 16. To start with, a deviation from the long-run PPP relation can occur because of a shock to the nominal exchange rate, domestic prices, or foreign prices. The impacts of shocks to these equations are shown in Figure 15; the left-hand panels show the adjustments over time of some selected individual variables, while the right-hand panels show the developments of the deviations from the estimated long-run PPP equilibrium.

230. A positive shock to domestic prices will lead temporarily to an appreciation of the real exchange rate. However, the rand will start to depreciate sharply after three-four quarters peaking after about eight quarters. In fact, the response of the exchange rate will be sufficiently strong to cause an overshooting effect, leading to a temporary real depreciation before equilibrium is restored, as illustrated in the dynamic effects on the cointegrating vector (denoted CV-ppp).

Figure 15
Figure 15

Impulse Responses of Shocks to the PPP Relation

Citation: IMF Staff Country Reports 2000, 042; 10.5089/9781451840957.002.A006

Figure 16
Figure 16

Impulse Responses of Shocks to the Money Demand Relation

Citation: IMF Staff Country Reports 2000, 042; 10.5089/9781451840957.002.A006

Table 23.

Weak Exogeneity Tests

article image
Note: * and ** indicate of the test at the 5 percent adn 1 percent significance level, respectively

Standard errors in parentheses

231. Likewise, a negative shock to the nominal exchange rate, that is, a depreciation of the rand, will almost immediately result in higher inflation. The half-life of such a shock seems to be about six quarters, a result that is in line with earlier results from the a matrix. The effect on real output (y) from a shock to the e equation is plotted in the middle panel on the left-hand side. Although a shock to the rand has a quite persistent effect on the real exchange rate (the rand remains, say, depreciated in real terms for several years before full adjustment takes place), the impact on real output is virtually zero.

232. With respect to the short-run comovements of the variables in the money demand function, the left-hand panels in Figure 16 shows the dynamic effect of a one-standard-error shock to the m3 equation. Such a shock can originate from different sources and should not necessarily be interpreted as a monetary policy shock. Nevertheless, it is interesting to note that, in contrast to a negative shock to the rand, a positive shock to money leads to an initial but temporary output gain that peaks after about one year. However, the excess money balances also lead to a sharp increase in the short-term interest rate after a couple of quarters. Together, these outcomes imply that the cointegrating relationship is driven back to its equilibrium as larger real balances are offset by higher output and higher short-term interest rates. Domestic prices start to pick up after five-six quarters, implying that real money balances adjust back to their initial level at the same time as the output effect tapers off and equilibrium is restored. Long-term interest rates also pick up after a couple of quarters, indicating that inflation expectations (correctly) rises.

233. Finally, a positive shock to real output leads quickly to higher demand for real balances, and broad money rises. The expected impact on domestic prices is in principle ambiguous, as it depends on whether the output shock is driven by a shift in aggregate demand or aggregate supply. However, the empirical results indicate that a positive shock to output generates inflationary pressures after about four-five quarters; although there will initially be some downward pressure on domestic prices, the end effect is a higher price level. Again, the magnitude of these inflationary pressures seems to be mitigated by a rise in short- term interest rates, possibly reflecting a tightening of monetary policy.

Appendix II: Inflation Targeting and Credibility Issues in Monetary Policy: Theoretical Arguments

234. The inflation-targeting approach to monetary policy is related to the debate in the theoretical literature on rules versus discretion in monetary policy, first initiated by Kydland and Prescott (1977) and Barro and Gordon (1983). In general, this literature shows that monetary policy might be subject to a “time-inconsistency” problem when conducted in a discretionary environment. This generates an “inflation bias,” that is, inflation will on average be higher than what the government desires, while employment and output will remain unaffected at their natural levels.

235. Various mechanisms for enhancing the credibility of monetary policy and reducing the inflation bias have been proposed. In particular, Rogoff (1985) shows that it is optimal to delegate monetary policy decisions to an independent central bank that is more “conservative” than the government (and society), in the sense that it attaches a higher weight to inflation than to output/employment. This reduces the inflation bias but is achieved at the expense of higher volatility in output and employment, that is, there is a “credibility versus flexibility trade-off.” However, Persson and Tabellini (1993) and Walsh (1995) show that the government can improve on the Rogoff solution by signing a simple linear performance contract with the central bank, which would penalize the central bank for positive inflation rates. If appropriately designed, such a contract could remove the inflation bias entirely without affecting the incentives for output stabilization.124 Svensson (1997b) then shows that the same solution can be achieved by delegating monetary policy to an independent central bank with an appropriately designed inflation target. Thus, an inflation- targeting regime could remove the inflation bias completely without compromising output stability. The purpose of this appendix is to review these arguments within the simple, “workhorse” model typically used in this literature.

236. A typical model on credibility issues in monetary policy can be viewed as a game between the private sector and the government in which the private sector sets nominal wages, while the government controls inflation. The sequencing of the game is usually assumed to go as follows: the private sector moves first, then a supply-side shock to the economy is realized, after which the policymaker determines the inflation rate, also implying the realization of real wages, employment, and output. In this setup, there are short-term employment and output gains from unexpectedly expansionary monetary policy. Thus, the supply side of the economy is described by an expectations-augmented Phillips curve (a “supply-surprise” curve), where unanticipated policy has real effects:


where xt is employment, x* is the natural level of employment (both variables expressed as natural logarithms), πt πteand are actual and expected inflation, respectively, and εt is a supply-side shock with mean zero.

237. The government’s (and society’s) loss function is assumed to be defined over inflation and (unemployment, according to


where π^ and x^ are the government’s inflation and employment objectives, respectively, and λ is the weight attached to unemployment relative to inflation. If the employment target is equal to full employment, the unemployment rate in the economy is given by x^-xt Minimizing the loss function (3) subject to (2) and assuming that the private sector forms expectations rationally yields


which can be substituted back into (2) to generate


Expressions (4) and (5) capture three important insights. First, as long as λ > 0 and the employment target, x^, is above the natural level of employment, x*, the expected rate of inflation will be higher than the government’s inflation objective.125 This is the so-called inflation bias in the economy, and this bias is a positive function of λ and x^-x*. Second, the expected rate of unemployment will be equal to the natural rate of unemployment; in particular, it will be unaffected by λ (the relative weight attached to unemployment). Third, the government will use monetary policy to stabilize the supply-side shocks, and the degree of this stabilization will be affected by λ; a higher λ is associated with less volatility in output and (un)employment.

238. Using the basic setup outlined above, Rogoff (1985) shows that the government can make itself better off by delegating monetary policy to an independent central bank with preferences that are more conservative than those of the government; more precisely, it is optimal for the government to delegate monetary policy to a central bank that has a λ that fulfills 0<λCB<λGOV,, where superscript CB and GOV stand for central bank and government, respectively.126 By examining expressions (4) and (5), it is clear that such a delegation will reduce the inflation bias and the volatility in inflation, but will increase the volatility in unemployment. Thus, although credibility is enhanced, it comes at the expense of less stability in output; there is a credibility versus flexibility trade-off.

239. However, Svensson (1997b) shows that, if monetary policy decisions are delegated to an independent central bank with an appropriately designed inflation target, the inflation bias can be eliminated without increasing the volatility in output. More precisely, assume that the central bank is given a mandate to achieve the inflation target π*, defined as π*=π̂λ(x̂x*),, while also stabilizing the economy. The central bank’s loss function would then be described by


where the only difference from (3) is that the central bank’s inflation objective now is given by the inflation target π* rather than π. Minimizing the loss function (3) subject to (2) now yields the following expressions for inflation and unemployment:




Comparing expressions (7) and (8) with (4) and (5), it can be noted that the inflation- targeting regime entirely removes the inflation bias; the expected rate of inflation will equal the inflation objective of the government, ft. As in the other cases (described above), the central bank still has an incentive to exploit the short-term Phillips curve, but this is now balanced against the desire to keep inflation at the target level π*. By defining the inflation target appropriately, the two effects could exactly balance each other, and the inflation outcome would equal the objective of the government (and society),π^. The central bank will still stabilize the supply-side shocks, and the magnitude of the stabilization will be the same as in the fully discretionary regime.

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Prepared by Gunnar Jonsson.


Industrial countries that have adopted inflation targeting include, in chronological order, New Zealand, Canada, United Kingdom, Sweden, Finland, Australia, and Spain. Useful references on their experiences with inflation targeting are Leiderman and Svensson (1995), Debelle (1997), Bernanke and Mishkin (1997), and Mishkin and Posen (1997). However, since January 1999, Finland and Spain should no longer be regarded as inflation-targeting countries, as these countries have joined the European Monetary Union.


The Czech Republic has operated a full-fledged inflation targeting regime since December 1997, while Brazil adopted inflation targeting in mid-1999. Israel, Chile, and Mexico are examples of countries that announce a one-year ahead inflation target as the objective of monetary policy, although other objectives (such as the nominal exchange rate) have also played an important role in the policy formulation (see, e.g., Morande and Schmidt-Hebbel (1999) for discussions). Poland and Hungary have recently announced multiyear inflation targets, with an eye to eventually joining the European Monetary Union. An examination of the scope for inflation targeting in developing countries can be found in Masson, Savastano, and Sharma (1997).


Core inflation excludes changes in mortgage interest costs as well as overdraft/personal loans, fresh-food prices, and various indirect taxes from the headline consumer price index.


See, for example, Svensson (1997a) for a theoretical discussion of the mechanisms of inflation targeting.


These aspects are recognized by the SARB. As stated by Casteleijn (1999) in the SARB’s Quarterly Bulletin, “[the need for] a continuous assessment of die relationship between the instruments of monetary policy and the inflation target… [and a] comprehensive forecasting framework… appear to preclude the immediate adoption of an explicit inflation target.”


The long-run coefficients on the income elasticity of the demand for broad money and on the nominal effective exchange rate in the “purchasing power parity” relationship were estimated at about unity. This is in line with empirical results found for many industrial countries (see Fase (1993) and Habermeier and Mesquita (1999)).


The theoretical argument for how an inflation-targeting regime could eliminate the inflation bias in an economy is described in Appendix II.


It should be noted that, from a welfare perspective, it might be optimal to not stabilize against certain supply-side shocks


Growth in broad money exceeded the guideline range of 6-10 percent every year between 1994 and 1998. However, by November 1999, the growth rate had fallen to SV2 percent (12-month rate).


For example, although the nominal effective exchange rate depreciated by 20 percent between March and September 1998, core inflation only increased from 7 percent in March 1998 to 8 percent in March 1999; it remained at about this level throughout 1999 despite a large increase in fuel prices


The United Kingdom, Sweden, and Canada are examples of countries that have adopted some form of band around the target of this magnitude.


Other studies have emphasized the importance of this argument in the case of South Africa and added that an explicit approval of mi inflation-targeting framework by the Ministry of Finance would enhance credibility and confidence in the government’s overall macroeconomic strategy (see CREFSA (1998) and Casteleijn (1999))


See South African Reserve Bank (1999b).


The median forecast (reported by Reuters) for headline inflation in 2001 was 5.5 percent, while it was 5.9 percent for core inflation.


New Zealand, Canada, and the Czech Republic are examples of countries that adopted a targeted path for inflation that declined over time.


The data set was extended to the period 1970:Q1-1998:Q2. See Jonsson (1999b) for a more complete description of this study, including definitions and data sources.


The method originated by Johansen (1991) was used


The parameters (j, and,…, are allowed to vary without restrictions, k is the lag length of the model, and et is a vector of normally distributed shocks with mean zero.


The Chi-square statistic of 2.89 for m3 in Table 23 is significant at the 10 percent level


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 affect real output only with (at least) a one-quarter lag.


Jonsson (1997) and Lockwood (1997) have extended this result to the case in which unemployment is persistent. In this case, it is shown that a state-contingent linear inflation contract removes the inflation bias without affecting output stabilization.


Put differently, whenever the natural rate of unemployment is higher than what the government desires (which in the current setup is assumed to be zero), the inflation bias will be positive


The proof can be found by inserting expressions (4) and (5) into the government’s loss function (3), defining the government’s true weight on unemployment relative to inflation to AG0V, and differentiating the loss function with respect to A.

South Africa: Selected Issues
Author: International Monetary Fund