monetary policy, inflation, unemployment and the phillips curve in south africa by aaron chicheke a

130 Pages·2010·0.89 MB·English

MONETARY POLICY, INFLATION, UNEMPLOYMENT AND THE PHILLIPS
CURVE IN SOUTH AFRICA

BY

AARON CHICHEKE

A DISSERTATION SUBMITTED IN FULL FULFILLMENT OF THE
REQUIREMENTS OF OBTAINING A MASTER OF COMMERCE DEGREE IN
ECONOMICS

DEPARTMENT OF ECONOMICS
FACULTY OF MANAGEMENT AND COMMERCE
UNIVERSITY OF FORT HARE
SOUTH AFRICA

SUPERVISOR: PROFESSOR M. NCUBE

2009
ABSTRACT

Inflation and unemployment are perhaps the two most important challenges that face the
South African economy of today. Firstly, the study examines the relationship between
monetary policy and the two economic fundamentals (inflation and unemployment), using
the VEC modeling technique. The model regresses the monetary policy variable against
inflation and unemployment growth over the period 1980-2008. The results suggest that (1)
there is a long run relationship between inflation and unemployment (2) monetary policy
reacts more to variations in inflation compared to variations in unemployment. Secondly, the
relationship between inflation and unemployment as explained by the Phillips curve is
investigated. The results show that there is a positive relationship between inflation and
unemployment.

Key words: Inflation, Unemployment, Monetary Policy, Phillips Curve.

ii
DECLARATION AND COPYRIGHT

I, the undersigned Aaron Chicheke, hereby declare that this dissertation is my own original
work and that it has not been submitted, and will not be presented at any other University for
a similar or any other degree award.

Signature ……………………………………………

Date ……../……. /……….

iii
ACKNOWLEDGEMENTS

A number of people have helped in the production of this dissertation. I would like to express
my sincere gratitude to the following people: my supervisor Professor M. Ncube for his
invaluable advice and assistance, to Mr. M. Maphosa, Mr. T. Murombo, Mr. K. Mudita, Ms.
I. Choga and Ms. L. Dabangana for their unlimited support and advice.
I would also like to acknowledge the wonderful work done by the brilliant and motivating
people from whom and around whom this paper was made possible. I am also grateful to the
staff and members of the Economics Department for the unlimited effort towards the
accomplishment of this Study.

iv
DEDICATION
Them, a far better people than I, without whom this paper would not be there-neither
I suspect would I.
So here goes the dissertation, dedicated to, Mr. and Mrs. Chicheke, Lue, Baba Letty naAmai
Letty, Baba Takura na Amai Takura vacho, the entire family members and friends, with love
and admiration.

v
LIST OF ACRONYMS

AD Aggregate demand
ADF Augmented Dickey Fuller
ARMA Auto Regression Moving Average
AS Aggregate supply
CLRM Classical Linear Regression Model
CMA Centred Moving Average
CPI Consumer Price Index
CPIX Consumer Price Index excluding mortgage interests
DF Dickey Fuller
DW Durbin Watson
ECT Error Correction Term
EG Engle and Granger
EME European Economic Union
GDP Gross Domestic Product
GMM Generalized Method of Moment
HP Hendrik-Prescott
H-M Huizinga and Mishkin
IS Investment and Savings equilibrium
LM Liquidity preference and Money supply equilibrium
M Money supply
MC Multi-Country
MPC Monetary Policy Committee
NAIRU Non Accelerating Rate of Inflation
NKPC New Keynesian Phillips Curve
OECD Organization for Economic Co-operation and Development
OLS Ordinary Least Square
P Price

vi
PVECM Parsimonious Vector Error Correction Model
SARB South African Reserve Bank
UK United Kingdom
USA United States of America
V Velocity
VAR Vector Auto Regression
VECM Vector Error Correction Model
SVAR Structural Vector Auto Regression
Y Income

vii
TABLE OF CONTENTS

ABSTRACT ................................................................................................................................... ii
DECLARATION AND COPYRIGHT ....................................................................................... iii
ACKNOWLEDGEMENTS ......................................................................................................... iv
DEDICATION ............................................................................................................................... v
LIST OF ACRONYMS ................................................................................................................ vi
TABLE OF CONTENTS ........................................................................................................... viii
LIST OF TABLES ........................................................................................................................ xi
Text Tables ................................................................................................................................. xi
LIST OF FIGURES ...................................................................................................................... xi
Text Figures ................................................................................................................................ xi
CHAPTER ONE ............................................................................................................................ 1
INTRODUCTION ......................................................................................................................... 1
1.1 Background of the study ........................................................................................................ 1
1.2. Statement of the problem ..................................................................................................... 3
1.3. Objectives of the study ......................................................................................................... 4
1.4. Rationale of the study ........................................................................................................... 5
1.5. Organization of the study ..................................................................................................... 5
CHAPTER TWO ........................................................................................................................... 6
THE SOUTH AFRICAN MONETARY SYSTEM .................................................................... 6
2.1 Introduction ........................................................................................................................... 6
2.2 The importance of Monetary Policy in South Africa ............................................................ 6
2.3. The evolution of monetary policy in South Africa ............................................................... 8
2.3.1. Monetary policy during the period 1980-1985 .............................................................. 8
2.3.2. Monetary policy during the period 1986-1999 .............................................................. 9
2.3.3. Monetary policy during the period 2000–2008 ........................................................... 10
2.4. Indicators and targets of Monetary Policy in South Africa ................................................ 12
2.4.1. Money supply growth .................................................................................................. 14
2.4.2. Interest rates ................................................................................................................ 16
2.4.3. Exchange rate .............................................................................................................. 18
2.4.4. Price stability or Inflation rate ..................................................................................... 19
2.5. The transmission mechanism in South Africa .................................................................... 21
2.5.1. The Interest Rate Channel ........................................................................................... 24
2.5.2. Broad Money channel ................................................................................................. 25

viii
2.5.3. Credit Channel ............................................................................................................. 25
2.5.4. Exchange Rate Channel ............................................................................................... 26
2.5.5. Other asset prices ......................................................................................................... 28
2.6. Financial markets in the monetary policy transmission process ........................................ 29
2.7. Inflation in South Africa ..................................................................................................... 30
2.8. Unemployment in South Africa ......................................................................................... 33
2.9. Inflation and unemployment in South Africa ..................................................................... 36
2.10. Monetary policy rules versus discretion ........................................................................... 38
2.11. Alternative monetary policy options ................................................................................ 39
2.11.1. Real targeting ............................................................................................................ 40
2.11.2. Employment targeting ............................................................................................... 41
2.12. Conclusion ........................................................................................................................ 42
CHAPTER THREE .................................................................................................................... 43
LITERATURE REVIEW ........................................................................................................... 43
3.1 Introduction ......................................................................................................................... 43
3.2. Theoretical literature .......................................................................................................... 43
3.2.1. The classical quantity theory of money ....................................................................... 43
3.2.2. The Keynesian Phillips curve ...................................................................................... 45
3.2.3. The monetarism theory ................................................................................................ 47
3.2.5. The New-Keynesian augmented Phillips curve .......................................................... 49
3.2.4. The Non-Accelerating Inflation Rate of Unemployment ............................................ 50
3.2.4 The Taylor rule ............................................................................................................. 51
3.3. Empirical literature ............................................................................................................. 52
3.3.1. Literature from Developed countries .......................................................................... 52
3.3.2. Literature from developing countries .......................................................................... 59
3.3.1. Literature from South Africa ....................................................................................... 64
3.4. Limitations of the reviewed studies .................................................................................... 70
3.5. Conclusion .......................................................................................................................... 73
CHAPTER FOUR ....................................................................................................................... 74
METHODOLOGY ...................................................................................................................... 74
4.1. Introduction ........................................................................................................................ 74
4.2. Data sources and definition of variables ............................................................................ 74
4.3. Research techniques ........................................................................................................... 76
4.3.1. Testing for stationarity ................................................................................................ 76
4.3.2. Dickey-Fuller and the Augmented Dickey-Fuller Tests ............................................. 77

ix
4.3.3. Cointegration and vector error correction modeling ................................................... 78
4.3.4 Diagnostic Checks ........................................................................................................ 82
4.3.5. Autocorrelation LM test .............................................................................................. 82
4.3.6. White heteroskedasticity test ....................................................................................... 82
4.3.7. Residual normality test ................................................................................................ 83
4.4. Conclusion .......................................................................................................................... 83
CHAPTER FIVE ......................................................................................................................... 84
ESTIMATING THE EFFECT OF MONETARY POLICY IN SOUTH AFRICA .............. 84
5.1. Introduction ........................................................................................................................ 84
5.2. Model specification ............................................................................................................ 84
5.4. Stationarity test ................................................................................................................... 85
5.4. Cointegration ...................................................................................................................... 88
5.5. Vector error correction modeling ....................................................................................... 90
5.6. Conclusion .......................................................................................................................... 95
CHAPTER SIX ............................................................................................................................ 96
ESTIMATING THE PHILLIPS CURVE IN SOUTH AFRICA ............................................ 96
6.1. Introduction ........................................................................................................................ 96
6.2. The Phillips curve model .................................................................................................... 96
6.3. Unit root test: The Phillips curve model ............................................................................ 97
6.4. Cointegration test: The Phillips curve model ..................................................................... 99
6.4. Vector Error Correction Model (VECM) estimates: The Phillips curve model ............... 101
6.6. Conclusion ........................................................................................................................ 104
CHAPTER SEVEN ................................................................................................................... 105
CONCLUSIONS AND POLICY RECOMMENDATIONS .................................................. 105
7.1. Summary of the study and conclusions ............................................................................ 105
7.2. Policy implications and recommendations ....................................................................... 106
7.3. Limitations of the study .................................................................................................... 108
7.4. Areas of further research .................................................................................................. 109
REFERENCES .......................................................................................................................... 110

x