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*

Abstract THE PAPER INVESTIGATES the key macro-economic indicators and how these affect monetary policy decisions on inflation targeting in South Africa. The paper theoretically examines the monetary transmission mechanism and the Taylor rule. The idea that monetary policy is not only affected by the variables stipulated by the Taylor rule for optimal monetary conditions provides the basis for the analysis. The paper estimates the repo rate as a rule for monetary policy in South Africa and the effect of an inclusion of the exchange rate and oil prices. The research findings indicate that macroeconomic indicators are vital for monetary decisions. Moreover providing a basis on how the macroeconomic indicators affect the inflation target and how a forecast of these effects may result in an optimal monetary policy. In addition future research may examine the inclusion of other variables that could be applied in estimating the Taylor rule in South Africa. JEL classifications: E52, E58, F31 Keywords: Optimal monetary policy, Taylor rule, Transmission mechanism, repo rate estimation

Monetary policy is a powerful tool, however it sometimes has unexpected consequences. To be successful in conducting monetary policy, the monetary authorities must have an accurate assessment of the timing and effect of their policies on the economy, thus requiring an understanding of the mechanisms through which monetary policy affects the economy. Macro-economic stability including control of inflation is a significant precondition for growth. The South African Reserve Bank conducts monetary policy within an inflation targeting framework. This was adopted in the first quarter of the new millennium and is still being used thereof (SARB, 2008:2). Economists generally agree that monetary policy should be primarily concerned with the pursuit of price stability (Smal and Jager, 2001:3). According to (Knedlik, 2006:637) the combination of the macroeconomic indicators and monetary policy decisions inherently result in an optimal monetary policy where the central bank does not react to shocks, thus focusing on targets that ensure internal and external stability. Macro-economic indicators are the key statistics of an economy and show the direction into which the economy is heading in and assists in decision making essentially for monetary policy decisions. South Africa adopted the inflation targeting framework in the year 2000. This formally endorsed the global consensus of low inflation as the ultimate goal of monetary policy. South Africa with the current inflation target range on CPIX1 set its inflation to be between 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 inflation differentials between South Africa and its trading partners would result in disruptive capital outflows (Van der merwe, 2004:1). According to Mboweni (2003:1) The target range had to be set at a level which would properly demonstrate commitment to lowering inflation, this essentially was for the credibility and management of the reserve bank. Conversely the Inflation infringed the upper end of the inflation target 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 price index (CPI) excluding the interest cost of mortgage bonds, for the historical metropolitan and other urban areas.)

when a year-on-year increase of 6, 3 per cent was recorded in April 2007 and has reached over 8 per cent in 2008. The pressures which were primarily responsible for the breach in the inflation target range were largely exogenous, emanating from oil and food price shocks, and have posed as a challenge to the central bank (SARB, 2008:2).Given the impact on inflation expectations, more generalised price-setting mannerisms and monetary policy credibility, the breach of the inflation target is of significant concern to the Monetary Policy Committee (MPC) of the South African Reserve Bank. Some of the key inflation risks have proved persistent, and there has been significant instability and uncertainty in the international environment (SARB, 2008:1). Therefore the paper seeks to examine the macroeconomic indicators that affect monetary decisions in South Africa. Firstly the paper will focus on the theoretical framework; the transmission mechanism and the Taylor rule. The transmission mechanism focuses on the interest rate channel used by South Africa.
1. LITERATURE REVIEW

The theoretical framework that appears to have had the most influence in the studies of monetary policy and macroeconomic indicators that affect the monetary decision making, are the transmission mechanism and the Taylor rule. This is discussed below and empirical evidence on other countries is in addition discussed in this section.
1.1. TRANSMISSION MECHANISM OF MONETARY POLICY

When the Reserve Bank decides to influence the change in the repurchase rate, it sets in motion a series of economic events (Knedlik, 2006:635). Economists refer to this chain of developments as 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 the monetary policy instrument and culminating in a change in real output and inflation, is not clear in many countries (Ortiz and Sturzenegger, 2007:669). A central bank needs to know the elasticity of inflation with respect to monetary policy shocks in order to determine the amount by which it should change the value of the policy instrument. These assist in the central bank obtaining a desired amount of change in inflation. In addition there should be knowledge of the average amount of time taken for the full impact of a monetary policy shock on inflation to materialize. With knowledge of the elasticity, this enables the central bank to take

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 rate channel is the basic Keynesian view; this is the traditional view where 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 influences aggregate demand and finally inflation (p). This is the channel that is essentially used by the South African Reserve bank (SARB). The SARB increases the repo rate, resulting in an increase in the real short-term interest rate (rt) (Michelle- Innes et al., 2008:4). The instance the official rate is changed; domestic banks thereafter adjust their lending rates, usually, but not necessarily, by the same amount as the policy change. Furthermore Knedlik (2006:636), stated that the interest rate channel appears stronger than the exchange rate channel in South Africa, this is due to the fact that it has a floating exchange rate hence it would make the economy more volatile to external shocks. Empirical evidence is discussed below analysing case studies of the transmission mechanism in practice. 1.1.1 Empirical evidence A growing amount of studies using different channels of the transmission mechanism have been explored empirically especially in developing countries. According to Maturu (2007:1) the interest rate channel and the exchange rate channel is important for developing countries. The channel commonly used to target inflation is the interest rate channel. Kenya for instance is a developing country with an inflation target of 5 percent. However studies have proved that for the effectiveness of the transmission mechanism in a country the elasticity of inflation with respect to monetary policy shocks has to be examined in addition to the average amount of time taken for the full impact of a monetary policy shock on inflation to materialize. These factors where difficult to determine in the Kenyan context the study indicated that both the interest rate and the exchange rate channel are important for Kenya (Maturu, 2007:23). A study on Turkey indicated that , Turkish monetary markets, were mainly affected by the real effective exchange rate and that short term capital flows dominate the course of monetary transmission mechanism. Thus the main channel of transmission of

the monetary policy into the economy is through the exchange rate channel which is inherently different from that of Kenya and South Africa. Hence policy makers should consider how the real effective exchange rate and short term capital flows change when applying to monetary policy instruments, employing also a business cycle perspective(Berument and Tescu, 2004:34). However according to empirical research by (Michelle- Innes et al., 2008:6) there is an indication that there is no significant long-run relationship between expected inflation and nominal short-term interest rates (Michelle- Innes et al., 2008:6). The SARB thus can artificially decrease the real short-term rate of interest through its influence over short-term interest rates, but this will only have a long-run positive impact on the economy if the induced decrease in real short-term rates filters through to real long-term rates of interest. Real interest rate adjustments appear to be occurring with the growing globalisation of saving and investment, which implies that real interest rates are increasingly determined globally. However, these changes suggest that in a small open emerging economy this still tends to be one-sided with the United States affecting real rates in these smaller economies, but not necessarily vice versa (Moreno, 2008:6). A number of central banks (for instance those of Chile, the Czech Republic, Mexico and Colombia) have said that the credibility of monetary policy and inflation targets has increased and have implications. One is that long-term rates are now less sensitive to a variety of shocks including changes in the policy rate, but this is seen as a desirable. For example, in Mexico, inflation targeting has implied more anchoring of expectations, as the dispersion of expectations among market forecasters has fallen (Moreno, 2008:8). Consequently there are rules such as the Taylor rule discussed below, that prescribe how a central bank should adjust its interest rate as a policy instrument systematically in response to developments in inflation and macroeconomic activity. In brief, these rules specify that monetary policy decisions are mainly driven by two factors, the outlook for inflation, as measured by the rate of change of the output deflator, and the outlook for real economic activity, as measured by the deviation of output from the economy's potential supply-the output gap. Following an influential study by Taylor (1993), these rules are commonly referred to as Taylor rules and these are discussed below (Clarida et al., 2000:147).
2.1 TAYLOR RULE

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

making it possible for monetary authorities to establish the econometric evaluation of specific alternative strategies, which they can use as the basis for its interest rate decisions (Knedlik, 2006:636); this is essential for decision making for monetary authorities. Taylor rules are a simple and transparent framework that assists in the organisation and the discussion of a systematic monetary policy. This adoption as a tool for policy discussions has facilitated a welcome convergence between monetary policy practice and monetary policy research and proved an important advance for both positive and normative analysis (Taylor, 2007:3). In addition the importance of a forward-looking focus in monetary policy has recently been emphasised in practice in inflationtargeting countries (Orphanides 2004:155). The policy rules that are commonly referred to as Taylor rules are simple reactive rules that adjust the interest rate policy instrument in response to developments in both inflation and economic activity (Knedlik, 2006:636).). The simple Taylor Rule characterises an interest rate feedback policy that is a linear function of the deviation between inflation and target inflation, and the output gap (that is, a measure of the deviation of output from capacity or trend output). I= c+ 1 (Inflation gap) + 2 (Output gap) +ut .. (1) et al., 2000:153). (Clarida

The dependence of the interest rate target upon the recent behaviour of inflation and of the output gap is prescribed, not simply because this is one way to exclude self-fulfilling expectations, but because it is assumed that the Taylor rule advocates for the central banks to reduce fluctuations in both of those variables (Clarida et al., 2000:156). According to Sanchez-Fung (2000:10) the rule is appropriate for developed countries, however developing countries have to add on other variables to the rule, and this is because developing countries have a different economic structure compared to developed countries. For instance developing countries tend to have greater volatility in their exchange rates; this would result in a bias in the Taylor rule; this is because the exchange rate is essentially used as a proxy for the behavior of foreign interest rates (Ferreira and Nel, 2005:12).Hence for developing countries that are open to trade it would be necessary for their monetary policy decisions to take 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

A case of a small developing economy uses the modified Taylor rule to estimate long and short run reactions of the Dominican 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 the monetary authorities suggest that they have been more systematic during the period 1985-98 than during 1970-84. This is due to the economic and political state during the period of the early 1980s. According to (Orphanides 2004:159) the (implied) rules given in equation (2) seem to suggest that the monetary authorities learn about how the economy evolves, and about the way in which their actions are transmitted. If they are assumed to behave rationally, it is unlikely that they would be willing to repeat experiences which in the past proved to be costly, both economically and politically. Taylor rules require that a country should target inflation as its primary goal. Australia and New Zealand adopted the inflation targeting framework and sine the beginning of the year there has been an infringement of the targeted inflation rates and this has been due primarily to the high oil prices experienced at the beginning of the year and high food prices. The Taylor rule hence failed to identify these external reactions that thus resulted in the infringement 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 open emerging market economies South Africa stands out for its stability due to its stronger weight on exchange rate and output. Furthermore as stated by (Ortiz and Sturzenegger, 2007:673) the weighting also indicates a stronger anti-inflation bias that appears to be the steadiest amongst all emerging economies. Inflation targeting, although it can be easily understood on its objectives; it is a highly complicated approach. The framework is highly demanding and according to Mboweni (2008:3) more difficult to implement than a monetary framework based on targeting monetary growth or a more discretionary framework. Central banks need to know the elasticity of inflation with respect to monetary policy shocks in order to determine the amount by which it should change the value of the policy instrument so as to obtain a desired amount of change in inflation. Conversely the Inflation infringed the upper end of the inflation target range of 3 to 6 per cent for the first time since August 2003 when a year-on-year increase of 6, 3 per cent was recorded in April 2007 and has reached over 13 percent to date. The deterioration has been noted by the MPC since its June 2006 meeting, when it began raising the repurchase (repo) rate in response to these risks (Markus 2007:1). However since most of the risks are exogenous factors these can not be controlled and remain persistent on the inflation outlook (SARB, 2008:1). The deterioration

was been noted by the MPC since its June 2006 meeting, when it began raising the repurchase (repo) rate in response to these risks. However since most of the risks are exogenous factors these can not be controlled and remain persistent on the inflation outlook (Aron and Muellbauer, 2002: 2). The study of the case studies between the countries mentioned above assist in the research as we shall investigate the variables that are necessary for a modified Taylor rule, moreover including an analysis of the major factors that affect the decisions made by the monetary policy authorities in South Africa. Many economists cite supply shocks and oil prices as the main force underlying the main drives of the monetary policy decisions (Aron and Muellbauer, 2002: 4). For instance an increase in the oil price could help explain periods of sharp price level increases however it is not clear how these can explain persistent inflation and how monetary policy decisions should be changed to accommodate these variations (Clarida et al., 2000:147). A monetary rule thus has to be created so as to increase the responsiveness of the monetary policy to the supply shocks to the economy. According to monetary theory the greater responsiveness leads to more stable inflation and more stable real GDP (Taylor 2000:9). The Taylor rule has been successful in emerging markets; in these countries the monetary policy rules have been especially useful for implementing inflation targeting. The conventional wisdom suggests that inflation targeting regime entails abolishing the exchange rate target n favor of an inflation target. Simple monetary policy instrument rules are feasible options for developing countries lacking the pre-requisites for more sophisticated targeting rules (Aron et al., 2003:428). On the other hand, counterfactual simulation confirms that macroeconomic performance can be improved, in terms of stability in inflation and output, when a simple Taylor rule is adopted. In this regard the parameter values (especially the inflation target) in the rule must be set 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 in 1974, and touched the lowest of 2.44 percent in 2002. This indicates poor macroeconomic performance Therefore, simple instrument rule like the Taylor rule might be a feasible option even though it may not be the optimal and it could serve as a first step to move from discretion to a more elaborate inflation targeting framework. The investigation found that despite the lack of pre-requisites for more elaborate policy rules and with weak institutions, developing countries can get benefits by the commitment to simple instrument rules. Possibilities of including other objectives and macroeconomic variables in the simple rules may also be explored. Fourth, the

parameters in the rule (especially the inflation target) must be adjusted according to the economic conditions of a specific economy (Malik, 2007: 32). The Taylor rules are therefore simple rules that prescribe how a central bank should adjust its interest rate policy instrument. After the rules modification for an emerging market may provide a systematic manner in response to developments in inflation and macroeconomic activity (Ortiz and Sturzenegger, 2007:670). Therefore the Taylor rule is essential and its specification in a developing economy differs substantially from that of a developed economy. The theoretical and empirical evidence have indicated that the responsiveness of the monetary policy to the economy and how the monetary policy is transmitted into the economy is essential. The paper thereafter looks into the methodology analysing the preliminary data and then the Taylor rule specification. 2. METHODOLOGY This paper examines the macroeconomic indicators and the effect on monetary policy decisions in South Africa. This section focuses 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; firstly there is the preliminary method and then there is an estimation of a modified Taylor model. From the literature review the main indicators identified for the purpose of the research are the oil prices and the real effective exchange rate. The data for these variables is from 2000q1 to 2008q2 this was collected from the South African Reserve Bank (SARB) and STATS S.A. In the preliminary method the primary focus is to illustrate through the use of graphs the correlation between the above mentioned variables and the repo rate. The modified Taylor model thus incorporates the main macroeconomic indicators into the simple Taylor rule. This is done in the case of Dominican Republic in a paper by (Sanchez-Fung, 2000:9), hence this is modified in the case of South Africa with the use 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 output function (2). The monetary rule encompasses two key targets of monetary 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 the level of nominal interest rate. The first component is the inflation rate which is measured by an average of inflation over the last four quarters. This in essence in South Africa this is the current CPIX. The second variable is the equilibrium real interest rate (r); which is commonly estimated as the difference between, the average interest rate and the average inflation rate Orphanides (2004:156).The first two factors provide a benchmark according to Kozicki (1999:6) this is because if the central banks main aim is to target inflation and output the interest rate would remain constant and inherently equal the two components. Thus the benchmark represents the level of interest which would keep inflation at its current equilibrium level. In addition the specification also includes the inflation target and the output gap. The inflation gap suggests that the interest rate be adjusted by a weighted value of the gap between price inflation and the target level which is set between 36% in South Africa. The output gap recommends that the interest rate be adjusted by a weighted value of the output gap where 2 serves 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 to reach the specification, stability, and dynamics of its monetary policy 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 exchange rate indicator would be a good candidate as one of the (implicit) targets of the monetary authorities. According to (Sanchez-Fung 2000:7) 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 the United states as one of its major trading partner; these have an influence on the modification of monetary policy and monetary policy decisions. Oil prices as the other variable included in the modified version; these tend to have a stagflation effect on the macro economy of an oil importing country: oil prices slow down the rate of growth and they lead to an increase in the price level and potentially 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 economy depends on various factors; these are basically the level of

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dependency on oil by the economy and the policy response of monetary and fiscal authorities (Orphanides and Wieland, 2008:308). An analysis of the oil price trends may provide a more precise measure of the REPO rate that the SARB may implement. The other variable (target) to be included in (2) is the output gap, as in the original Taylor (1993) model. Such a gap is intended to be a test of inflationary pressures: the farthest above potential real GDP is the highest is the probability of an overheating of the system (Sanchez-Fung, 2000:8). Equation (2) is estimated using quarterly data for the period 2000-2008. The effective exchange rate data is obtained from the South African reserve bank (SARB). The output gap is expressed as a percentage deviation of South Africas Gross domestic product derived from Stats S.A. The output gap is approximated by its linear trend over the sample period. The oil prices are obtained from the SARB. In addition the inflation gap is given as an expression of the CPIX derived from the latter. A well known problem of wrongly measured data is highly expected, this is because developing countries possess the problem of data mining; thus the estimation of the Taylor rule would have to be corrected for these problems. However of the case of South Africa this is not applicable as all the data is readily available; however the SARB 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 the estimation of the Taylor rule would have to be corrected in this case. Therefore it would be useful to allow lagged reactions by the monetary authorities in the analysis being taken although the analysis is dealing with quarterly data. An autoregressive distributed lag specification of order one would be most appropriate. The corrected 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 Oil pricest + 7 (Oil prices t-1) + t (3) (Sanchez-Fung, 2000:11). Estimation of the model is vulnerable to certain problems since it is quarterly data. The main problem is the problem of stationarity and certain tests where done so as to correct this problem. Firstly the tests for stationarity where done with the use of correlogram in addition to this the augmented dickey fuller test was carried out. The choice of a Taylor modified model is the autogressive distributed lag specification of order one ADL (I, 1). It is chosen 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 make decisions for the transmission of the monetary policy through its decisions into the economy. A supply side shock such as a sudden rise in oil prices or a drought affecting food prices may cause a movement away from the target, but over which monetary policy has little influence in the first instance. Monetary policy can be expected to react to second round effects and apparent changes induced in inflationary expectations (Van der Merwe, 2004:4). Tests for estimation problems where carried out tests by the use of the Durbin Watson test. Given that South Africa is a small open economy it is expected that the simple Taylor rule would not produce the perfect fit hence the modified Taylor rule would have to be used. The model is thereby an autoregressive model at first difference terms. Firstly the specification is intended on indicating the relationship between the real effective exchange rate and the repo rate these are regressed separately as shown in table (1), thereafter the relationship between repo rate and the oil prices. The repo rate being the dependent variable this is aimed at observing the level of significance the REER and oil prices have on monetary policy decisions. Inherently analysing the degree of effect this may have on the Monetary Policy committee estimation of the interest rate and whether this as a macro economic indicator has a major impact on the interest rate. Since there is the use of quarterly data test for stationary indicated that, at order zero the regression results for both REER and Oil prices indicated that the variable is non-stationary because the correlogram declines geometrically with the Autocorrelation Partial correlation results starting out high and declining to zero. In addition the p-values are highly significant conclude that the variable is nonstationary. At order one the results indicate a difference from those of level terms. The values tend to oscillate around zero hence this is an indication of stationarity. The p-value moreover confirms this as they 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 negative relationship between the Repo rate and REER. According to economic theory this is as expected. However in the year 20002003q3 there is a positive relationship that is illustrates in fig (a). This could be due to the fact that the inflation targeting framework had just been adopted and the Monetary authorities where not

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taking the REER into consideration. As time went on a negative relationship is illustrates as expected. The relationship therefore indicates that the REER is negatively correlated with the repo rate. There are high fluctuations however in the REER and the repo rate does not change as much. This illustration could indicate to what the degree 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 the relationship between oil prices and the repo rate indicate. Apriori a positive relationship between the repo rate and the oil prices. The graph shows that as the oil prices increased the repo rate moreover increased. Where the oil prices were low the repo rate was also decreased this is noted in the 2004 and 2005 period where the repo rate was reduced by over 100 basis points to 7.5 percent in 2004 and 7 percent in 2005. Oil prices hence have an effect on the transmission of monetary policy into the economy and should thereby be considered by monetary authorities in decision making and 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 the oil prices used as a proxy for supply side shocks. The preliminary analysis thus illustrates the linear relationship between the two variables, real effective exchange rate and oil prices with the repo rate. This analysis indicates that there is a linear relationship between the variables one being negative and the latter being a positive relationship. Hence these variables are significant in monetary decision making. The next section of the paper shows the estimation of a modified Taylor rule. Moreover using the repo rate as a proxy for the monetary decisions made in the country the modified Taylor rule shows the significance of the additional variables to the repo rate. c. Estimating the modified Taylor rule The modified Taylor rule as mentioned above is the inflation gap and the output gap with an extension of additional variables the real effective exchange rate and the oil prices. The estimation of the modified Taylor rule are shown below and the results are discussed thereafter. Table 1. Modified Taylor rule model regression ADL I (1) Coefficien t C Inflation gap 6.106563 0.106545 Std. Error 0.44274 9 0.02614 1 Tstatist ic 13.792 39 4.0758 09 Pvalue 0.0000 0.0004

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Output gap REER Oil prices

0.007324 -0.006596 0.019203

0.00291 6 0.01471 9 0.00672 7 Adjuste d RSquared Durbin Watson Stat

2.5119 40 0.4481 37 2.8548 04 0.5241 00 2.0009 85

0.6576 0.0002 0.0082

R-squared 0.585506 F-statistic Schwarz

13.42364 1.290313

The signs shown in the regression for both the REER and oil prices are as expected. Stemming from the preliminary analysis the oil prices have a positive relationship with the Repo rate being the dependant variable and the REER has a negative relationship with the dependant variable. The REER and the oil prices are statistically significant shown by the p-values. Hence we could conclude that the variables affect decision making by monetary authorities. The output gap according to the results is insignificant this could be due the fact that the output gap measurement is subject to uncertainty. According to Orphanides and Van Norden(2002:570) the estimation of the output gap for any given method may not be reliable this is because firstly, the output data may be revised, implying that output gaps estimated from real-time data may differ from those estimated from data for the same period published at a later time. In addition, the arrival of new data may instead result in a revision of the model of the economy, which in turn revises the output gap (Soderstrom, 2002:127). The modified model with the lagged variables illustrates that adding more variables to the rule would improve the results. The adjusted R2 reveal that the overall goodness of fit has been improved. The lagged tstatistic of the inflation gap is significant for the rule specification. A priori the REER coefficient sign is as expected. The original model as shown in equation (1) as the results shown in table (3) indicate, the adjusted R2 improves when more variables are added to the specification as shown in table (1) hence the goodness of fit is improved. Cointegration tests were carried out so as to analyse whether or not a long run relationship exists between the variables in the modified Taylor rule specification (3). This assists in understanding the effect that these

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variables have on the monetary decisions through the relationships established between the variables. The Engel granger method was used for this estimation performed through the augmented dickey fuller unit root test (Guajarati, 2003:385). The Durban Watson statistic is cointergrated suggesting that there is cointergration. Moreover, the Durbin Watson statistics is equal to 2, suggesting that autocorrelation is not a significant problem (Guajarati, 2003:387) this is shown in table (2). The overall the results are promising. The goodness of fit as shown in table (1) as shown by the adjusted R2 statistic is fairly high. The series is tested for cointegration and a relationship is suggested in the series. Hence it can thereby be noted that although the SARB does not explicitly target the Taylor rule; South Africa is still largely dependent on imports and the exchange rate, due to imported inflation is a key determinant of inflation (van der Merwe 2004:9). Monetary authorities should thereby monitor the exchange rate changes closely (Sanchez-Fung 2000:12) and this could result in the SARB reacting to the information contained in the exchange rate movements in the economy, as would be expected. The Monetary policy committee, from the results obtained the REER and oil prices have an impact on their decision making criteria. There are more macroeconomic indicators that affect the decisions that the central bank authorities make. If these are taken into consideration the monetary policy may react to the exogenous changes and hence manage to stabilise inflation effectively.

2. CONCLUSIONS and LIMITATION

The aim of the paper has been to identify the effect of the main macroeconomic indicators on monetary decisions in South Africa. This has been done through the use of macroeconomic indicators namely the REER and the oil prices as a proxy for oil shocks, examining the significance these indicators have on decisions made by the monetary policy committee with the repo rate as a proxy for this research. However there are limitations to this research. The conclusions concerning robustness and reliability should however be treated cautiously. By econometric standards the sample period and size are small. Moreover the limitations sited when calculating the output gap. The output gap suggested in Taylor's analysis of the rule's empirical fit maybe quite different from the theoretically correct measure, as the efficient level of output may be affected by a wide variety of real exogenous disturbances that are not taken into account in the output gap calculation. From the results above it would be imprudent to state that the monetary policy committee should concentrate on the two additional variables but should take them into consideration to assist in decision making. Other macro economic indicators should be taken into consideration when making monetary decisions but the model neglects the other models. The discretionary monetary policy framework that South

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Africa follows also creates limitations because the decisions they reach are not transparent hence whether or not the macroeconomic indicators are of significance or not to their decision making is not explicitly available for analysis. Despite these limitations the results presented above are encouraging. The results illustrate how macroeconomic indicators are highly significant for decision making purposes and the estimation of the repo rate for monetary policy. A recommendation thereof considering the financial turmoil the country is facing primarily due to the external shocks the monetary authorities therefore could adjust the weighting of these variables in the monetary decisions. The operation of inflation targeting has been successful, however the breach of the inflation target range has compromised the credibility of monetary policy hence the monetary authorities could take use of the macroeconomic indicators as part of departure for discussions of monetary policy, both within the SARB and the public domain. Moreover the monetary policy committee could also revise the inflation target range of 3-6 percent factoring in the exogenous shocks that the economy faces. In addition to these recommendations other macro economic indicators should be taken into account that has a significant impact on the decisions made and these should also be taken into 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 Augmented Dickey-Fuller test statistic Test critical values: 1% level 5% level -7.010625 -2.653401 -1.953858 Prob.* 0.0000

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10% level *MacKinnon (1996) one-sided p-values.

-1.609571

Augmented Dickey-Fuller Test Equation Coefficient D(UHAT(-1)) D(UHAT(-1),2) D(UHAT(-2),2) R-squared Adjusted R-squared Durbin-Watson stat -3.093125 1.258071 0.509966 0.832499 0.818541 2.000985 Std. Error 0.441205 0.319880 0.177581 t-Statistic -7.010625 3.932949 2.871740 Prob. 0.0000 0.0006 0.0084 0.231796 12.91040

Mean dependent var S.D. dependent var

Table 3. The original Taylor rule

Dependent Variable: REPO_RATE Method: Least Squares Date: 09/20/08 Time: 14:29 Sample (adjusted): 2000Q1 2008Q1 Included observations: 33 after adjustments Coefficient C OUTPGAP INFLAT_GAP R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 7.308876 0.003508 0.118335 0.472270 0.437088 0.412690 5.109383 -16.04540 13.42364 0.000069 Std. Error 0.090059 0.003142 0.023144 t-Statistic 81.15616 1.116635 5.113063 Prob. 0.0000 0.2730 0.0000 7.545455 0.550052 1.154266 1.290313 1.200042 0.873721

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

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