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

Abstract

We develop a structural cointegrated vector autoregressive (VAR) model with weakly exogenous foreign variables, known as an augmented VECM or VECX*, suitable for a small open economy like South Africa. This model is novel for South Africa in two ways: it is the first VECX* developed to analyse monetary policy and the first model that uses time-varying trade weights to create the foreign series. We impose three significant long-run relations (augmented purchasing power parity, uncovered interest parity and Fisher parity) to investigate the effect of a monetary policy shock on inflation. The results suggest the effective transmission of monetary policy.