CONSTITUTIONS, INSTITUTIONS AND ECONOMIC CONVERGENCE AN.docVIP

INFLATION TARGETTING IN SOUTH AFRICA: A VAR ANALYSIS G Woglom* Abstract T he first part of the paper analyses CPI inflation targeting in an open economy context. Inflation targeting makes the exchange rate less flexible in response to foreign shocks and thus lessens the automatic stabilisation provided by flexible exchange rates. The second part uses VAR techniques to study the relative frequencies of different kinds of shocks impinging on the South African, New Zealand and Canadian economies. The results suggest that South Africa is not a good candidate for an inflation target relative to the other two countries because of the relative importance of foreign shocks and of the weak linkage between monetary policy and inflation. 1. Introduction A number of industrial countries have recently adopted inflation targets with an apparent degree of success (see Bernanke and Mishkin (1997)). This apparent success has led some to speculate that inflation targets might also be desirable for countries at somewhat lower stages of economic development (see Masson et al (1997)), including South Africa. The idea of an inflation target for South Africa has, in fact, drawn growing support as a practical response to the increasing difficulty of monetary targeting with a liberalised capital account (see Casteleijn (1999), Stals (1999) and Mboweni(1999)). This paper looks at the historical evidence to judge whether South Africa is a good candidate for an inflation target. In particular, the South African evidence is compared to the evidence from Canada and New Zealand, two countries that have adopted inflation targets in 1991 and 1990, respectively. The main conclusion of the paper is negative primarily for two reasons: 1) The exchange rate is highly volatile in South Africa, and some of this volatility appears to be stabilising the effects of external shocks. Under inflation targeting, monetary policy would have to dampen these exchange rate movements which are affecting the c