MONETARY POLICY AND MACRO-ECONOMIC INDICATORS

8/3/2019 MONETARY POLICY AND MACRO-ECONOMIC INDICATORS

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FACULTY OF COMMERCE

School of Economics

MONETARY POLICY (THE TAYLOR RULE)

AND MACRO-ECONOMIC INDICATORS FOR

SOUTH AFRICA

Minor Thesis Dissertation in partial fulfilment of Programme

CATHRINE MUTOGO*

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Abstract

THE PAPER INVESTIGATES the key macro-economic indicators andhow these affect monetary policy decisions on inflation targeting inSouth Africa. The paper theoretically examines the monetarytransmission mechanism and the Taylor rule. The idea thatmonetary policy is not only affected by the variables stipulated bythe Taylor rule for optimal monetary conditions provides the basisfor the analysis. The paper estimates the repo rate as a rule formonetary policy in South Africa and the effect of an inclusion of theexchange rate and oil prices. The research findings indicate thatmacroeconomic indicators are vital for monetary decisions.

Moreover providing a basis on how the macroeconomic indicatorsaffect the inflation target and how a forecast of these effects mayresult in an optimal monetary policy. In addition future research mayexamine the inclusion of other variables that could be applied inestimating the Taylor rule in South Africa.JEL classifications:E52, E58, F31Keywords: Optimal monetary policy, Taylor rule, Transmissionmechanism, repo rate estimation

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Monetary policy is a powerful tool, however it sometimes hasunexpected consequences. To be successful in conducting monetarypolicy, the monetary authorities must have an accurate assessmentof the timing and effect of their policies on the economy, thusrequiring an understanding of the mechanisms through whichmonetary policy affects the economy. Macro-economic stabilityincluding control of inflation is a significant precondition for growth.

The South African Reserve Bank conducts monetary policy within aninflation targeting framework. This was adopted in the first quarterof the new millennium and is still being used thereof (SARB, 2008:2).Economists generally agree that monetary policy should be primarilyconcerned with the pursuit of price stability (Smal and Jager,

2001:3).According to (Knedlik, 2006:637) the combination of the macro-

economic indicators and monetary policy decisions inherently resultin an optimal monetary policy where the central bank does not react

to shocks, thus focusing on targets that ensure internal and externalstability. Macro-economic indicators are the key statistics of aneconomy and show the direction into which the economy is headingin and assists in decision making essentially for monetary policydecisions. South Africa adopted the inflation targeting framework inthe year 2000. This formally endorsed the global consensus of lowinflation as the ultimate goal of monetary policy. South Africa withthe current inflation target range on CPIX1 set its inflation to bebetween the target range of 3 to 6 per cent on a continuous basis.

The major factor which impelled the South African Reserve Bank to

adopt inflation targeting was the concern that the inflationdifferentials between South Africa and its trading partners wouldresult in disruptive capital outflows (Van der merwe, 2004:1).According to Mboweni (2003:1) The target range had to be set at alevel which would properly demonstrate commitment to loweringinflation, this essentially was for the credibility and management ofthe reserve bank.

Conversely the Inflation infringed the upper end of the inflationtarget range of 3 to 6 per cent for the first time since August 2003

1 According to Mboweni (2003:1) define CPIX as the consumer priceindex (CPI) excluding the interest cost of mortgage bonds, for thehistorical metropolitan and other urban areas.)

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when a year-on-year increase of 6, 3 per cent was recorded in April2007 and has reached over 8 per cent in 2008. The pressures whichwere primarily responsible for the breach in the inflation targetrange were largely exogenous, emanating from oil and food priceshocks, and have posed as a challenge to the central bank (SARB,2008:2).Given the impact on inflation expectations, moregeneralised price-setting mannerisms and monetary policycredibility, the breach of the inflation target is of significant concernto the Monetary Policy Committee (MPC) of the South AfricanReserve Bank. Some of the key inflation risks have provedpersistent, and there has been significant instability and uncertaintyin the international environment (SARB, 2008:1). Therefore thepaper seeks to examine the macroeconomic indicators that affectmonetary decisions in South Africa. Firstly the paper will focus on

the theoretical framework; the transmission mechanism and theTaylor rule. The transmission mechanism focuses on the interestrate channel used by South Africa.

1. LITERATURE REVIEW

The theoretical framework that appears to have had the mostinfluence in the studies of monetary policy and macroeconomicindicators that affect the monetary decision making, are thetransmission mechanism and the Taylor rule. This is discussed below

and empirical evidence on other countries is in addition discussed inthis section.

1.1. TRANSMISSION MECHANISM OF MONETARY POLICY

When the Reserve Bank decides to influence the change in therepurchase rate, it sets in motion a series of economic events(Knedlik, 2006:635). Economists refer to this chain of developmentsas the transmission mechanism of monetary policy (Smal and Jager,2001:5). The monetary policy transmission mechanism, which is the

sequence of events starting with a change in the value of themonetary policy instrument and culminating in a change in realoutput and inflation, is not clear in many countries (Ortiz andSturzenegger, 2007:669). A central bank needs to know theelasticity of inflation with respect to monetary policy shocks in orderto determine the amount by which it should change the value of thepolicy instrument. These assist in the central bank obtaining adesired amount of change in inflation. In addition there should beknowledge of the average amount of time taken for the full impact

of a monetary policy shock on inflation to materialize. Withknowledge of the elasticity, this enables the central bank to take

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timely measured policy actions aimed at controlling inflation(Knedlik, 2006:635).

There are many types of monetary transmission mechanism;these include the interest rate channel, the exchange rate channel,other asset price effects, and the credit channel. The interest ratechannel is the basic Keynesian view; this is the traditional viewwhere monetary tightening is transmitted to the real economy by:

Tight monetary policy --> interest rate (up) --> investment(down) --> output (down).(Nualtaranee, 2003:1)

In the interest channel, the real interest rate influencesaggregate demand and finally inflation (p). This is the channel that isessentially used by the South African Reserve bank (SARB). The

SARB increases the repo rate, resulting in an increase in the realshort-term interest rate (rt) (Michelle- Innes et al., 2008:4). Theinstance the official rate is changed; domestic banks thereafteradjust their lending rates, usually, but not necessarily, by the sameamount as the policy change. Furthermore Knedlik (2006:636),stated that the interest rate channel appears stronger than theexchange rate channel in South Africa, this is due to the fact that ithas a floating exchange rate hence it would make the economymore volatile to external shocks. Empirical evidence is discussed

below analysing case studies of the transmission mechanism inpractice.

1.1.1 Empirical evidence

A growing amount of studies using different channels of thetransmission mechanism have been explored empirically especiallyin developing countries. According to Maturu (2007:1) the interestrate channel and the exchange rate channel is important fordeveloping countries. The channel commonly used to target inflation

is the interest rate channel. Kenya for instance is a developingcountry with an inflation target of 5 percent. However studies haveproved that for the effectiveness of the transmission mechanism in acountry the elasticity of inflation with respect to monetary policyshocks has to be examined in addition to the average amount oftime taken for the full impact of a monetary policy shock on inflationto materialize. These factors where difficult to determine in theKenyan context the study indicated that both the interest rate andthe exchange rate channel are important for Kenya (Maturu,

2007:23). A study on Turkey indicated that , Turkish monetarymarkets, were mainly affected by the real effective exchange rateand that short term capital flows dominate the course of monetarytransmission mechanism. Thus the main channel of transmission of

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the monetary policy into the economy is through the exchange ratechannel which is inherently different from that of Kenya and SouthAfrica. Hence policy makers should consider how the real effectiveexchange rate and short term capital flows change when applying tomonetary policy instruments, employing also a business cycleperspective(Berument and Tescu, 2004:34).

However according to empirical research by (Michelle- Innes etal., 2008:6) there is an indication that there is no significant long-runrelationship between expected inflation and nominal short-terminterest rates (Michelle- Innes et al., 2008:6). The SARB thus canartificially decrease the real short-term rate of interest through itsinfluence over short-term interest rates, but this will only have along-run positive impact on the economy if the induced decrease inreal short-term rates filters through to real long-term rates of

interest. Real interest rate adjustments appear to be occurring withthe growing globalisation of saving and investment, which impliesthat real interest rates are increasingly determined globally.However, these changes suggest that in a small open emergingeconomy this still tends to be one-sided with the United Statesaffecting real rates in these smaller economies, but not necessarilyvice versa (Moreno, 2008:6). A number of central banks (for instancethose of Chile, the Czech Republic, Mexico and Colombia) have saidthat the credibility of monetary policy and inflation targets has

increased and have implications. One is that long-term rates are nowless sensitive to a variety of shocks including changes in the policyrate, but this is seen as a desirable. For example, in Mexico, inflationtargeting has implied more anchoring of expectations, as thedispersion of expectations among market forecasters has fallen(Moreno, 2008:8).

Consequently there are rules such as the Taylor rule discussedbelow, that prescribe how a central bank should adjust its interestrate as a policy instrument systematically in response todevelopments in inflation and macroeconomic activity. In brief,

these rules specify that monetary policy decisions are mainly drivenby two factors, the outlook for inflation, as measured by the rate ofchange of the output deflator, and the outlook for real economicactivity, as measured by the deviation of output from the economy'spotential supply-the output gap. Following an influential study by

Taylor (1993), these rules are commonly referred to as Taylor rulesand these are discussed below (Clarida et al., 2000:147).

2.1 TAYLOR RULE

The South African Reserve bank uses the interest rate as themain instrument for the conduct of monetary policy. The Taylor ruleprovides a useful framework for the analysis of historical policy

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making it possible for monetary authorities to establish theeconometric evaluation of specific alternative strategies, which theycan use as the basis for its interest rate decisions (Knedlik,2006:636); this is essential for decision making for monetaryauthorities. Taylor rules are a simple and transparent frameworkthat assists in the organisation and the discussion of a systematicmonetary policy. This adoption as a tool for policy discussions hasfacilitated a welcome convergence between monetary policypractice and monetary policy research and proved an importantadvance for both positive and normative analysis (Taylor, 2007:3).Inaddition the importance of a forward-looking focus in monetarypolicy has recently been emphasised in practice in inflation-targeting countries (Orphanides 2004:155). The policy rules that arecommonly referred to as Taylor rules are simple reactive rules that

adjust the interest rate policy instrument in response todevelopments in both inflation and economic activity (Knedlik,2006:636).). The simple Taylor Rule characterises an interest ratefeedback policy that is a linear function of the deviation betweeninflation and target inflation, and the output gap (that is, a measureof the deviation of output from capacity or trend output).

I= c+ 1 (Inflation gap) + 2 (Output gap) +ut .. (1) (Claridaet al., 2000:153).

The dependence of the interest rate target upon the recentbehaviour of inflation and of the output gap is prescribed, not simplybecause this is one way to exclude self-fulfilling expectations, butbecause it is assumed that the Taylor rule advocates for the centralbanks to reduce fluctuations in both of those variables (Clarida etal., 2000:156).

According to Sanchez-Fung (2000:10) the rule is appropriatefor developed countries, however developing countries have to addon other variables to the rule, and this is because developing

countries have a different economic structure compared todeveloped countries. For instance developing countries tend to havegreater volatility in their exchange rates; this would result in a biasin the Taylor rule; this is because the exchange rate is essentiallyused as a proxy for the behavior of foreign interest rates (Ferreiraand Nel, 2005:12).Hence for developing countries that are open totrade it would be necessary for their monetary policy decisions totake into account foreign interest rate movements. Therefore the

Taylor rule would require the inclusion of the exchange rate as one

of the variables.

1.2.1 Empirical evidence

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A case of a small developing economy uses the modified Taylor rule to estimate long and short run reactions of theDominican Republics monetary policy during the period of 1970-98(Judd and Rudebusch 1998:13). The study thus uses the modified.

The conclusion suggested that the implicit reactions of themonetary authorities suggest that they have been more systematicduring the period 1985-98 than during 1970-84. This is due to theeconomic and political state during the period of the early 1980s.According to (Orphanides 2004:159) the (implied) rules given inequation (2) seem to suggest that the monetary authorities learnabout how the economy evolves, and about the way in which theiractions are transmitted. If they are assumed to behave rationally, itis unlikely that they would be willing to repeat experiences which inthe past proved to be costly, both economically and politically.

Taylor rules require that a country should target inflation asits primary goal. Australia and New Zealand adopted the inflationtargeting framework and sine the beginning of the year there hasbeen an infringement of the targeted inflation rates and this hasbeen due primarily to the high oil prices experienced at thebeginning of the year and high food prices. The Taylor rule hencefailed to identify these external reactions that thus resulted in theinfringement of the inflation target (Head 2008:1).

South Africa currently uses the inflation targeting framework

which was adopted in the year 2000. Relative to other openemerging market economies South Africa stands out for its stabilitydue to its stronger weight on exchange rate and output.Furthermore as stated by (Ortiz and Sturzenegger, 2007:673) theweighting also indicates a stronger anti-inflation bias that appearsto be the steadiest amongst all emerging economies. Inflationtargeting, although it can be easily understood on its objectives; it isa highly complicated approach. The framework is highly demandingand according to Mboweni (2008:3) more difficult to implementthan a monetary framework based on targeting monetary growth or

a more discretionary framework. Central banks need to know theelasticity of inflation with respect to monetary policy shocks in orderto determine the amount by which it should change the value of thepolicy instrument so as to obtain a desired amount of change ininflation. Conversely the Inflation infringed the upper end of theinflation target range of 3 to 6 per cent for the first time sinceAugust 2003 when a year-on-year increase of 6, 3 per cent wasrecorded in April 2007 and has reached over 13 percent to date. Thedeterioration has been noted by the MPC since its June 2006

meeting, when it began raising the repurchase (repo) rate inresponse to these risks (Markus 2007:1). However since most of therisks are exogenous factors these can not be controlled and remainpersistent on the inflation outlook (SARB, 2008:1). The deterioration

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was been noted by the MPC since its June 2006 meeting, when itbegan raising the repurchase (repo) rate in response to these risks.However since most of the risks are exogenous factors these can notbe controlled and remain persistent on the inflation outlook (Aronand Muellbauer, 2002: 2).

The study of the case studies between the countriesmentioned above assist in the research as we shall investigate thevariables that are necessary for a modified Taylor rule, moreoverincluding an analysis of the major factors that affect the decisionsmade by the monetary policy authorities in South Africa. Manyeconomists cite supply shocks and oil prices as the main forceunderlying the main drives of the monetary policy decisions (Aronand Muellbauer, 2002: 4). For instance an increase in the oil pricecould help explain periods of sharp price level increases however it

is not clear how these can explain persistent inflation and howmonetary policy decisions should be changed to accommodate thesevariations (Clarida et al., 2000:147). A monetary rule thus has to becreated so as to increase the responsiveness of the monetary policyto the supply shocks to the economy. According to monetary theorythe greater responsiveness leads to more stable inflation and morestable real GDP (Taylor 2000:9). The Taylor rule has been successfulin emerging markets; in these countries the monetary policy ruleshave been especially useful for implementing inflation targeting. The

conventional wisdom suggests that inflation targeting regime entailsabolishing the exchange rate target n favor of an inflation target.Simple monetary policy instrument rules are feasible options fordeveloping countries lacking the pre-requisites for moresophisticated targeting rules (Aron et al., 2003:428). On the otherhand, counterfactual simulation confirms that macroeconomicperformance can be improved, in terms of stability in inflation andoutput, when a simple Taylor rule is adopted. In this regard theparameter values (especially the inflation target) in the rule must beset according to the conditions of the economy under consideration

rather than by relying on the ones suggested by the Taylor rule.Pakistan has experienced cycles in inflation and real economic

activity in the history. Inflation reached the peak at 23 percent in1974, and touched the lowest of 2.44 percent in 2002. This indicatespoor macroeconomic performance Therefore, simple instrument rulelike the Taylor rule might be a feasible option even though it maynot be the optimal and it could serve as a first step to move fromdiscretion to a more elaborate inflation targeting framework. Theinvestigation found that despite the lack of pre-requisites for more

elaborate policy rules and with weak institutions, developingcountries can get benefits by the commitment to simple instrumentrules. Possibilities of including other objectives and macroeconomicvariables in the simple rules may also be explored. Fourth, the

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parameters in the rule (especially the inflation target) must beadjusted according to the economic conditions of a specific economy(Malik, 2007: 32).

The Taylor rules are therefore simple rules that prescribe howa central bank should adjust its interest rate policy instrument. Afterthe rules modification for an emerging market may provide asystematic manner in response to developments in inflation andmacroeconomic activity (Ortiz and Sturzenegger, 2007:670).

Therefore the Taylor rule is essential and its specification in adeveloping economy differs substantially from that of a developedeconomy.

The theoretical and empirical evidence have indicated thatthe responsiveness of the monetary policy to the economy and howthe monetary policy is transmitted into the economy is essential.

The paper thereafter looks into the methodology analysing thepreliminary data and then the Taylor rule specification.

2. METHODOLOGY

This paper examines the macroeconomic indicators and theeffect on monetary policy decisions in South Africa. This sectionfocuses on the techniques that are essential for this examination,primarily using the key macroeconomic indicators identified in the

literature review research.The types of techniques for the analysis are as follows; firstlythere is the preliminary method and then there is an estimation of amodified Taylor model. From the literature review the mainindicators identified for the purpose of the research are the oil pricesand the real effective exchange rate. The data for these variables isfrom 2000q1 to 2008q2 this was collected from the South AfricanReserve Bank (SARB) and STATS S.A. In the preliminary method theprimary focus is to illustrate through the use of graphs thecorrelation between the above mentioned variables and the repo

rate. The modified Taylor model thus incorporates the mainmacroeconomic indicators into the simple Taylor rule. This is done inthe case of Dominican Republic in a paper by (Sanchez-Fung,2000:9), hence this is modified in the case of South Africa with theuse of the key macro economic indicators in the country.

Taylors rule advocates that the setting of the interest rate (i)should be determined by the rate of inflation (1) and the outputfunction (2). The monetary rule encompasses two key targets ofmonetary policy: a low and stable inflation rate, and a sustainable

growth of output. The Taylor rule is thus given by:

I= Inflation rate+r + 1 (Inflation gap) + 2 (Output gap) +ut .. (1)

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The Taylor rule advocates that there are four factors that affect thelevel of nominal interest rate. The first component is the inflationrate which is measured by an average of inflation over the last fourquarters. This in essence in South Africa this is the current CPIX. Thesecond variable is the equilibrium real interest rate (r); which iscommonly estimated as the difference between, the averageinterest rate and the average inflation rate Orphanides(2004:156).The first two factors provide a benchmark according toKozicki (1999:6) this is because if the central banks main aim is totarget inflation and output the interest rate would remain constantand inherently equal the two components. Thus the benchmarkrepresents the level of interest which would keep inflation at itscurrent equilibrium level. In addition the specification also includesthe inflation target and the output gap. The inflation gap suggests

that the interest rate be adjusted by a weighted value of the gapbetween price inflation and the target level which is set between 3-6% in South Africa. The output gap recommends that the interestrate be adjusted by a weighted value of the output gap where 2serves as the weighting (Taylor, 2007:5).However the specification of the Taylor rule for a small emerging

economy should pay particular attention to other variables so as toreach the specification, stability, and dynamics of its monetarypolicy and rules. The modified version of Taylors rule to be

estimated can be written as:

I= inflation rate + r +1 (Inflation gap) + 2 (Output gap)+ 3(REERt)+ 4 (Oil Prices)+ 6 (It-1)+ut . (2)

South Africa currently uses the interest rate channel; an exchangerate indicator would be a good candidate as one of the (implicit)targets of the monetary authorities. According to (Sanchez-Fung2000:7) the inclusion of the real effective exchange rate (REER)would be most appropriate because if the economy is small and

open it thereby results in an increase in the exchange rate volatility. This research analyses the REER between South Africa and theUnited states as one of its major trading partner; these have aninfluence on the modification of monetary policy and monetarypolicy decisions. Oil prices as the other variable included in themodified version; these tend to have a stagflation effect on themacro economy of an oil importing country: oil prices slow down therate of growth and they lead to an increase in the price level andpotentially an increase in the inflation rate (and may even reduce

the level of output i.e. cause a recession), (Carlstrom and Fuerst,2005:2). However the impact of an oil shock on an economydepends on various factors; these are basically the level of

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dependency on oil by the economy and the policy response ofmonetary and fiscal authorities (Orphanides and Wieland,2008:308). An analysis of the oil price trends may provide a moreprecise measure of the REPO rate that the SARB may implement.

The other variable (target) to be included in (2) is the output gap, asin the original Taylor (1993) model. Such a gap is intended to be atest of inflationary pressures: the farthest above potential real GDPis the highest is the probability of an overheating of the system(Sanchez-Fung, 2000:8).

Equation (2) is estimated using quarterly data for the period2000-2008. The effective exchange rate data is obtained from theSouth African reserve bank (SARB). The output gap is expressed as apercentage deviation of South Africas Gross domestic productderived from Stats S.A. The output gap is approximated by its linear

trend over the sample period. The oil prices are obtained from theSARB. In addition the inflation gap is given as an expression of theCPIX derived from the latter.

A well known problem of wrongly measured data is highlyexpected, this is because developing countries possess the problemof data mining; thus the estimation of the Taylor rule would have tobe corrected for these problems. However of the case of South Africathis is not applicable as all the data is readily available; however theSARB operates a forward looking inflation targeting monetary policy

framework which responds to changes in main economic variables(Sanchez-Fung, 2000:10). These estimations take time hence theestimation of the Taylor rule would have to be corrected in this case.

Therefore it would be useful to allow lagged reactions by themonetary authorities in the analysis being taken although theanalysis is dealing with quarterly data. An autoregressive distributedlag specification of order one would be most appropriate. Thecorrected equation would therefore be:

It= Inflation rate +r + 1 (Inflation gap) t-1 + 2 (REER) t+ 3

(REER) t-1 + 4 (Output gap) + 5 (Output gapt-1) + 6 Oilpricest + 7 (Oil prices t-1) + t (3) (Sanchez-Fung,2000:11).

Estimation of the model is vulnerable to certain problemssince it is quarterly data. The main problem is the problem ofstationarity and certain tests where done so as to correct thisproblem. Firstly the tests for stationarity where done with the use ofcorrelogram in addition to this the augmented dickey fuller test was

carried out. The choice of a Taylor modified model is theautogressive distributed lag specification of order one ADL (I, 1). It ischosen so as to account for the problems of wrongly measured data.Moreover this method is selected because the monetary policy

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committee reacts at a lag to the economic conditions so as to makedecisions for the transmission of the monetary policy through itsdecisions into the economy.A supply side shock such as a suddenrise in oil prices or a drought affecting food prices may cause amovement away from the target, but over which monetary policyhas little influence in the first instance. Monetary policy can beexpected to react to second round effects and apparent changesinduced ininflationary expectations (Van der Merwe, 2004:4). Testsfor estimation problems where carried out tests by the use of theDurbin Watson test.

Given that South Africa is a small open economy it is expectedthat the simple Taylor rule would not produce the perfect fit hencethe modified Taylor rule would have to be used. The model isthereby an autoregressive model at first difference terms. Firstly the

specification is intended on indicating the relationship between thereal effective exchange rate and the repo rate these are regressedseparately as shown in table (1), thereafter the relationship betweenrepo rate and the oil prices. The repo rate being the dependentvariable this is aimed at observing the level of significance the REERand oil prices have on monetary policy decisions. Inherentlyanalysing the degree of effect this may have on the Monetary Policycommittee estimation of the interest rate and whether this as amacro economic indicator has a major impact on the interest rate.

Since there is the use of quarterly data test for stationaryindicated that, at order zero the regression results for both REER andOil prices indicated that the variable is non-stationary because thecorrelogram declines geometrically with the Autocorrelation Partialcorrelation results starting out high and declining to zero. In additionthe p-values are highly significant conclude that the variable is non-stationary. At order one the results indicate a difference from thoseof level terms. The values tend to oscillate around zero hence this isan indication of stationarity. The p-value moreover confirms this asthey are greater therefore failing to reject the null hypothesis and

concluding that the variable is stationary at first difference terms(Gujarati 2003:621).

2.1 EMPIRICAL RESULTS

a. Preliminary data analysis Repo Rate vs. REER

The preliminary data indicates that there is a negativerelationship between the Repo rate and REER. According to

economic theory this is as expected. However in the year 2000-2003q3 there is a positive relationship that is illustrates in fig (a).This could be due to the fact that the inflation targeting frameworkhad just been adopted and the Monetary authorities where not

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taking the REER into consideration. As time went on a negativerelationship is illustrates as expected. The relationship thereforeindicates that the REER is negatively correlated with the repo rate.

There are high fluctuations however in the REER and the repo ratedoes not change as much. This illustration could indicate to what thedegree the monetary policy reacts to REER.

Fig (a) Repo Rate vs. REER

b. Preliminary data analysis Repo Rate vs. Oil Prices

An analysis of fig (b) that subsequently illustrates therelationship between oil prices and the repo rate indicate. Apriori apositive relationship between the repo rate and the oil prices. Thegraph shows that as the oil prices increased the repo rate moreoverincreased. Where the oil prices were low the repo rate was alsodecreased this is noted in the 2004 and 2005 period where the reporate was reduced by over 100 basis points to 7.5 percent in 2004and 7 percent in 2005. Oil prices hence have an effect on the

transmission of monetary policy into the economy and shouldthereby be considered by monetary authorities in decision makingand the estimation of the repo rate for the monetary policy(Orphanides and Wieland, 2008:309).

Fig (b) Repo Rate vs. Oil Prices

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With the repo rate used as a proxy for monetary decisions and theoil prices used as a proxy for supply side shocks. The preliminaryanalysis thus illustrates the linear relationship between the twovariables, real effective exchange rate and oil prices with the reporate. This analysis indicates that there is a linear relationshipbetween the variables one being negative and the latter being apositive relationship. Hence these variables are significant inmonetary decision making. The next section of the paper shows theestimation of a modified Taylor rule. Moreover using the repo rate as

a proxy for the monetary decisions made in the country the modifiedTaylor rule shows the significance of the additional variables to therepo rate.

c. Estimating the modified Taylor rule

The modified Taylor rule as mentioned above is the inflationgap and the output gap with an extension of additional variables thereal effective exchange rate and the oil prices. The estimation of themodified Taylor rule are shown below and the results are discussed

thereafter.

Table 1. Modified Taylor rule model regression ADL I (1)

Coefficien

t

Std.

Error

T-

statist

ic

P-

value

C 6.106563 0.442749

13.79239

0.0000

Inflationgap

0.106545 0.026141

4.075809

0.0004

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Outputgap

0.007324 0.002916

2.511940

0.6576

REER -0.006596 0.01471

9

-

0.448137

0.0002

Oilprices

0.019203 0.006727

2.854804

0.0082

R-squared 0.585506 Adjusted R-Squared

0.524100

F-statistic 13.42364 DurbinWatson

Stat

2.000985

Schwarz 1.290313

The signs shown in the regression for both the REER and oil pricesare as expected. Stemming from the preliminary analysis the oil priceshave a positive relationship with the Repo rate being the dependantvariable and the REER has a negative relationship with the dependantvariable. The REER and the oil prices are statistically significant shown by

the p-values. Hence we could conclude that the variables affect decisionmaking by monetary authorities.

The output gap according to the results is insignificant this could bedue the fact that the output gap measurement is subject to uncertainty.According to Orphanides and Van Norden(2002:570) the estimation of theoutput gap for any given method may not be reliable this is because firstly,the output data may be revised, implying that output gaps estimated fromreal-time data may differ from those estimated from data for the sameperiod published at a later time. In addition, the arrival of new data mayinstead result in a revision of the model of the economy, which in turnrevises the output gap (Soderstrom, 2002:127).

The modified model with the lagged variables illustrates that addingmore variables to the rule would improve the results. The adjusted R2

reveal that the overall goodness of fit has been improved. The lagged t-statistic of the inflation gap is significant for the rule specification. A priorithe REER coefficient sign is as expected. The original model as shown inequation (1) as the results shown in table (3) indicate, the adjusted R2

improves when more variables are added to the specification as shown intable (1) hence the goodness of fit is improved.

Cointegration tests were carried out so as to analyse whether or nota long run relationship exists between the variables in the modified Taylorrule specification (3). This assists in understanding the effect that these

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variables have on the monetary decisions through the relationshipsestablished between the variables. The Engel granger method was used forthis estimation performed through the augmented dickey fuller unit roottest (Guajarati, 2003:385). The Durban Watson statistic is cointergratedsuggesting that there is cointergration. Moreover, the Durbin Watsonstatistics is equal to 2, suggesting that autocorrelation is not a significantproblem (Guajarati, 2003:387) this is shown in table (2).

The overall the results are promising. The goodness of fit as shownin table (1) as shown by the adjusted R2 statistic is fairly high. The series istested for cointegration and a relationship is suggested in the series.Hence it can thereby be noted that although the SARB does not explicitlytarget the Taylor rule; South Africa is still largely dependent on imports andthe exchange rate, due to imported inflation is a key determinant ofinflation (van der Merwe 2004:9). Monetary authorities should thereby

monitor the exchange rate changes closely (Sanchez-Fung 2000:12) andthis could result in the SARB reacting to the information contained in theexchange rate movements in the economy, as would be expected.

The Monetary policy committee, from the results obtained the REERand oil prices have an impact on their decision making criteria. There aremore macroeconomic indicators that affect the decisions that the centralbank authorities make. If these are taken into consideration the monetarypolicy may react to the exogenous changes and hence manage to stabiliseinflation effectively.

2. CONCLUSIONS and LIMITATION

The aim of the paper has been to identify the effect of the mainmacroeconomic indicators on monetary decisions in South Africa. This hasbeen done through the use of macroeconomic indicators namely the REERand the oil prices as a proxy for oil shocks, examining the significancethese indicators have on decisions made by the monetary policycommittee with the repo rate as a proxy for this research. However thereare limitations to this research. The conclusions concerning robustness and

reliability should however be treated cautiously. By econometric standardsthe sample period and size are small. Moreover the limitations sited whencalculating the output gap. The output gap suggested in Taylor's analysisof the rule's empirical fit maybe quite different from the theoreticallycorrect measure, as the efficient level of output may be affected by a widevariety of real exogenous disturbances that are not taken into account inthe output gap calculation. From the results above it would be imprudentto state that the monetary policy committee should concentrate on the twoadditional variables but should take them into consideration to assist in

decision making. Other macro economic indicators should be taken intoconsideration when making monetary decisions but the model neglects theother models. The discretionary monetary policy framework that South

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Africa follows also creates limitations because the decisions they reach arenot transparent hence whether or not the macroeconomic indicators are ofsignificance or not to their decision making is not explicitly available foranalysis.

Despite these limitations the results presented above areencouraging. The results illustrate how macroeconomic indicators arehighly significant for decision making purposes and the estimation of therepo rate for monetary policy. A recommendation thereof considering thefinancial turmoil the country is facing primarily due to the external shocksthe monetary authorities therefore could adjust the weighting of thesevariables in the monetary decisions. The operation of inflation targetinghas been successful, however the breach of the inflation target range hascompromised the credibility of monetary policy hence the monetaryauthorities could take use of the macroeconomic indicators as part of

departure for discussions of monetary policy, both within the SARB and thepublic domain. Moreover the monetary policy committee could also revisethe inflation target range of 3-6 percent factoring in the exogenous shocksthat the economy faces. In addition to these recommendations othermacro economic indicators should be taken into account that has asignificant impact on the decisions made and these should also be takeninto account with the aim of targeting inflation.

Table 2. Unit root test: Augmented dickey fuller test

Null Hypothesis: D(UHAT) has a unit root

Exogenous: None

Lag Length: 2 (Automatic based on SIC, MAXLAG=7)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -7.010625 0.0000

Test critical values: 1% level -2.653401

5% level -1.953858

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10% level -1.609571

*MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Coefficient Std. Error t-Statistic Prob.

D(UHAT(-1)) -3.093125 0.441205 -7.010625 0.0000

D(UHAT(-1),2) 1.258071 0.319880 3.932949 0.0006

D(UHAT(-2),2) 0.509966 0.177581 2.871740 0.0084

R-squared 0.832499 Mean dependent var 0.231796

Adjusted R-squared 0.818541 S.D. dependent var 12.91040Durbin-Watson stat 2.000985

Table 3. The original Taylor rule

Dependent Variable: REPO_RATE

Method: Least Squares

Date: 09/20/08 Time: 14:29

Sample (adjusted): 2000Q1 2008Q1Included observations: 33 after adjustments

Coefficient Std. Error t-Statistic Prob.

C 7.308876 0.090059 81.15616 0.0000

OUTPGAP 0.003508 0.003142 1.116635 0.2730

INFLAT_GAP 0.118335 0.023144 5.113063 0.0000

R-squared 0.472270 Mean dependent var 7.545455

Adjusted R-squared 0.437088 S.D. dependent var 0.550052S.E. of regression 0.412690 Akaike info criterion 1.154266

Sum squared resid 5.109383 Schwarz criterion 1.290313

Log likelihood -16.04540 Hannan-Quinn criter. 1.200042

F-statistic 13.42364 Durbin-Watson stat 0.873721

Prob(F-statistic) 0.000069

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MONETARY POLICY AND MACRO-ECONOMIC INDICATORS