The effect of the exchange rate on inflation in South Africa

The depreciation of the rand in recent years has been one of the indicators of recession in South Africa. The unpredictability of the rand and its volatility has led to great inflationary pressure. The process of examining the relationship between South Africa’s exchange rate and inflation rate has become increasingly relevant down the years. This study analyses the relationship between exchange rate and inflation in South Africa from 1994Q1 to 2017Q4. Its objective is to establish the effect of the exchange rate on inflation in South Africa. The non-linear autoregressive distributed lag (NARDL) model is employed as the method of estimation. Trends in exchange rate and inflation between 1980 and 2017 are analysed. Monetary régimes and shifts in inflation down the years are discussed. Key events like the Asian financial crisis of 1998, the introduction of the inflation targeting framework in 2000, the significant depreciation of the rand in 2001 and the global financial crisis in 2008/09 all contributed majorly in the way the country’s monetary policy and inflation take the form they have today. The literature identifies the exchange rate pass-through, purchasing power parity (PPP) and absolute power parity (APP) as exchange rate theories, all in which are discussed in detail. Empirical evidence suggests a predominantly positive relationship between inflation rate and exchange rate in other African countries as well as in developed countries. The exchange rate pass-through in South Africa appears to have lessened down the years. The NARDL model is discussed in detail in the research methodology chapter. The main reason for using this method of estimation is to capture asymmetry effects that may exist between inflation and exchange rate. First and second generation unit root tests, like Ng-Perron, DF-GLS and KSS, are discussed in detail to capture the stationarity of the variables. The variables of interest include nominal effective exchange rate, Brent crude oil prices, prime lending rate, unemployment rate and M3 money supply. This is done in line with the literature. The vector autoregressive (VAR) model is briefly discussed in the research methodology chapter. The findings of the study reveal that an appreciation in the exchange rate decreases the inflation rate. The results also reveal that a depreciation in the exchange rate decreases the inflation rate, which happens not to be in line with economic theory. This implies that a depreciation has a negative effect on inflation. A positive relationship between oil price and inflation is found to exist. A negative relationship is found to exist between M3 money supply and inflation. There is a positive relationship between prime lending rate and inflation. The study found that the Phillips curve does not hold in South Africa. The estimated VAR model results reveal that there exists unidirectional causality running from nominal effective exchange rate to inflation rate. The impulse response function reveals a negative relationship between exchange rate and inflation. Therefore, the study proposes that policymakers evolve means of evaluating exchange rate volatility, and that lending rates be made flexible. This will help curb inflation in South Africa