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Pfungwa Sandengu Topic: Examining the relationship between Monetary Policy, Inflation and Economic Growth in South Africa 1 | Page 1. Introduction Policy makers are much concerned about the level of economic growth and inflation in an economy. Monetary policy and fiscal policy changes are designed to reduce demand on capital markets, to minimise inflationary pressures, boost economic growth and to address unemployment, standards of living and social welfare. Monetary policy can be defined as ways of managing the supply of money. The SARB defined it as measures used by monetary authorities to influence the quantity of money or the rate of interest in order to achieve economic growth, full employment and stable price. According to Mishkin (2009) the goals of the monetary policy are high employment, price stability, economic growth, interest rate stability and financial market stability and stability in the exchange markets. These goals are in line with the mandate of our central bank. In South Africa different monetary approach frameworks have been used to attain the goals of monetary policy. Casteleijn (2002) explained the monetary regimes that were used, they include: liquidity asset ratio based system for the period of 1960- 1980, mixed system framework for the period of 1980-1985 and cost of cash reserve based system for the period of1986-1999 and the inflation targeting monetary policy framework for period of 2000 up to date. South Africa is one of the African countries to adopt the inflationary targeting monetary policy framework in February 2000. The move from other policy targeting framework was motivated by the mandate of the South African reserve bank. The mandate of the Central bank is to achieve and maintain price stability in the interest of a balanced and sustainable economic growth. Attaining of the above mandates is believed to create a favourable environment for achieving the goals of the monetary policy and improving living standards of all South Africans . The framework is characterized by setting an inflation rate that needs to be achieved within a certain period, say 12 months. The repo rate is the major instrument of the inflation targeting monetary policy. The inflation target is set after the government consultation with the reserve bank. Monetary policy Committee (MPC) is responsible for pegging the interest rates. The MPC takes into account the international factors that have an impact on inflation before pegging an interest rate which they think is suitable to maintain low inflation levels and to achieve a desired growth. According to Kumo (2015) the SARB initial target was CPIX (CPI for metropolitans) before switching on to headline CPI. The reason being that in the early stages of the inflation targeting framework headline CPI was influenced by changes in the bank’s monetary policy. The inflation target range was set as 3-6% since the adoption of the inflation targeting framework, with exception of the year 2004 and 2005 whereby the range was reduced to a band of 3-5%. Mishkin (2009) highlighted that the major goal of the monetary policy is price stability. Price stability helps to increase the level of investment, employment creation, improving the standards of living, maintaining a balanced growth and improve competitiveness. It is undeniable that an economy with steady and stable price level will achieve higher economic growth. Instability in prices creates uncertainty which makes decision making process more cumbersome. Uncertainty environment lower economic growth since it creates fear in investors. High levels of inflation are associated with negative growth and have huge negative impact on an economy. Expansionary and contractionary of monetary policy and use of Pfungwa Sandengu Topic: Examining the relationship between Monetary Policy, Inflation and Economic Growth in South Africa 2 | Page different monetary policy instrument allows an economy to have low levels of inflation and to achieve desired growth. Pre-1994, expansionary monetary and fiscal policies were used to stimulate demand in the economy in an attempt to achieve high employment levels and sustained growth. Such short term demand stimulating accommodative monetary policies resulted in accelerating inflation and increased deficit. On the other hand government expenditure was financed through borrowing and higher taxation. Expectations of high and rigid inflation were the order of the day despite sound monetary policies. Huge deficit and increased debt were also experienced. Establishment of the new government in 1994 changed the overall economic management by focusing on achieving economic stability. The government abandoned the demand side interventions and focused on supply side interventions. Trade and industry policies were also pursued. Monetary policy goals was decided to be stabilising economic cycles and creation of a suitable environment of achieving sustainable growth. Since the adoption of inflationary target framework, the economy has managed to achieve low levels of inflations within the target range, however economic growths remain fragile. The economy is characterised with massive bargaining powers from labour unions, high unemployment rate, high crime rate and low economic growth. Whenever South Africa is having a health growth, current account deficit is also experienced, and the reason being that the growth rate is associated with more net imports. Deteriorating growth outlook and uncomfortable inflation rate in 2014 were the challenges of the monetary policy that was caused by the exposure of the South African economy to the international market. Negative growth in the first quarter of 2014 was a result of repeated supply shocks since 2009 [Monetary Policy review, 2014]. Attaining high growth is closely linked to attaining high employment. High economic growth is achieved when there is a low unemployment level through investment in capital equipment. In Mishkin (2009), the role of monetary policy in boosting economic growth is questionable. Growth policies are crafted through encouraging business to invest, households to save and through issuing of tax incentives. According to Mboweni (2000), money supply and price level are not the determinants of economic growth, or any model of production that adds to economic growth. However money have been identified as an instrument that allows factors of production and the goods and service market to function more efficiently. Mboweni (2000) explained that monetary policy plays a crucial role through the maintaining of price stability. Price stability reduces the escalating of prices that may results due to short run demand and supply shocks in the goods and service market. Production process is affected by the monetary policy through interest rates. Interest rates have an impact on the exchange rate and demand, hence an impact of monetary policy on economic growth and performance. Mboweni (2000) iterated that preserving of the value of the rand and maintaining low levels of inflation will enhance long run economic growth and performance. Amongst previous studies, money supply was used as a monetary policy instrument when testing for the relationship between monetary theory, inflation and economic growth. In South Pfungwa Sandengu Topic: Examining the relationship between Monetary Policy, Inflation and Economic Growth in South Africa 3 | Page African context, researches carried out were mainly focused on the impact of the inflation targeting monetary policy on economic growth, price volatility and inflation. This study attempts to investigate the short run and long run relationships between monetary policy instruments, inflation and economic growth in South Africa. The researcher fitted multivariate vector auto-regressive models (VAR) to the time series data of inflation, monetary policy variables and Economic growth. Several economic tests have been conducted using the data for the period of 1994 to 2014. The research is organised such that section 2 deals with theoretical and empirical literature review. Methodology and model specification and data sources are dealt with in Section 3. Results Section 4 is for Presentation and interpretation of results Section 5 presents recommendation and conclusion. Pfungwa Sandengu Topic: Examining the relationship between Monetary Policy, Inflation and Economic Growth in South Africa 4 | Page 2. LITERATURE REVIEW 2.1. Theoretical Literature The theoretical literature was developed from the quantity theory of money and the Keynesian liquidity theory. According to Olumuyiwa and Mathew (2012) monetarist treat money as exogenous, and they believe that supply of money and price level have a long run relationship. The quantity theory of money is based on the assumption that interest rates do not play any role in on money demand. The theory is was developed by Irvin Fischer based on the equation of exchange. ……………………...1 Where PY is viewed as nominal GDP. Velocity of circulation (V) links nominal GDP (PY) to with money demand (M). ……………....................2 According to Fischer use of alternatives to money reduces the demand of money hence the increase in velocity [Mishkin, 2010]. The Classical economist views were explained by the quantity theory of money. The classical theory was built on the assumption that the economy operate at full employment and that velocity of circulation was fixed. This assumption can be explained by the Fischer equation of exchange as follows: ℎ ………3 Mishkin (2010) cited that Fischer’s view was that k is a constant, therefore nominal income (PY) determines money demand (M). This brought about the conclusion that interest rate have no effect on one. The idea was motivated by the belief that money is held for transactions. Since the classical economist believed that the economy operates at full employment, changes in money supply results in proportional change in price levels. Humphrey (1974) explained that an increase in money creates disequilibrium between price and money supply. Therefore prices have to adjust until equilibrium is restored. This explains the neutrality of money, that is, money has no effect on real variables such as employment and output. Olumuyiwa and Mathew (2012) cited that the transmission mechanism of the monetarist is that consumption and income are directly affected by money. Prices and interest rates are affected by security transactions. Spending in investment is encouraged by decline in interest rate. Though interest rates are used to capture the adjustment of financial assets, they are not identified by transmission mechanism as an important variable. Milton Friedman explained the contractionary in money supply is necessary to maintain a reasonable inflation. Monetary theory states that money supply and price level have a causal relationship. According to a priori short run effect of money supply is on output, while the long run effect rest on price level. Money supply is known to be a lead indicator to inflation. Milton Freidman allowed inflation to vary with the changes in expected inflation. By allowing these changes in velocity of circulation, Freidman dismissed the classical notion that velocity was stable [Humphrey, 1974]. Freidman iterated that once velocity has moved to match the new inflation levels, there will be a proportional change between increases in money and inflation. Pfungwa Sandengu Topic: Examining the relationship between Monetary Policy, Inflation and Economic Growth in South Africa 5 | Page The liquidity preference theory of money demand explains the importance of interest rates. The motives for holding money are transcactionary, precautionary and speculative motive. In line with the classical economists, Keynes emphasized that transactionary motives was determined by people’s transactions with respect to their income. Holding money for uncertainities is believed to be related to income. Since money can be viewed as a store of value, it is demanded for speculative purposes. Interest rates determine how much money to hold for speculative purposes. According to Miskin (2010), Keynes explained that if the expected return for holding money is greater than that of bonds one would hold money over bonds. The rise in interest rates will cause the demand for money to fall and that of bonds to rise. This explains the reasoning behind the negative correlation between demand for money and interest rates , ………………..4 The inclusion of interest rates differentiate Keynes liquidity preference theory from fishers money demand. Under liquidity preference theory velocity is not stationary, it is influenced by interest rates. There is a positive relationship between interest rates and velocity. Velocity is also influenced by changes in expectations. Keynes is one of the economist to criticize the quantity theory of money. He argued that the assumption of full employment was not practical [Humphrey, 1974]. Keynes argued that if the economy is operating in less than full employment, an increase in money supply will results in output and employment as propounded by Humphrey (1974). Interest rate provide the primary link between the economy and money supply. Transmission mechanism in a Keynesian world links final demand and monetary policy indirectly through the interest rates [Olumuyiwa and Mathew, 2012]. Interest rate fall to a rise in money supply, thus stimulating investment. The stimulation of investment will induce the gross domestic product. Monetary transmission mechanism describe how policy induced changes in nominal stock or short term interest rates impact real variables such as aggregate output and employment.. Specific channels of money transmission operates through the effects of monetary policy on interest rates, exchange rates, equity and bank lending. Resent researches on transmission mechanism seeks to understand how channels works in dynamic stochastic and general equilibrium models. The Keynesians and the Monetarists believe that Gross domestic product can be influenced by money via different channels. The Keynesians transmission mechanism is that the stimulus effect of GDP from money supply rests on interest rate. On the other hand, the Monetarist believe that there is a direct effect of money supply on GDP. 2.2. Empirical literature Chaudhry at al. (2012) studies were carried out in Pakistan using time series data from 1973-2010. The study was aimed at investigating the impact of the variables of monetary policy and inflation on economic growth. The results reveals that the exchange rate have an impact on real gross domestic product (RGDP). A unidirectional causality was found at RGDP on financial depth, domestic credit and budget deficit. The findings further suggest that the expansionary
