Monetary policy and inflation in South Africa: A VECM augmented with foreign variables

We develop a structural cointegrated vector autoregressive (VAR) model with weakly exogenous foreign variables, suitable for a small open economy like South Africa. This type of model is known as an augmented vector error correction model (VECM), referred to by VECX*. We compile the foreign variables with trade-weighted three-year moving average data for 32 countries, to account for the significant change in trade shares over time. This model is novel for South Africa, in two ways: it is the first VECX* developed to analyse monetary policy in the country and the first model that uses time-varying trade weights for the creation of the foreign series. We find three significant long-run economic relations: the augmented purchasing power parity, the uncovered interest parity and the Fisher parity. These long-run relations are imposed on the VECX* to investigate the effect of a monetary policy shock on inflation. The results suggest the effective functioning of the monetary transmission mechanism in South Africa.