Inflation and Output Growth Dynamics in South Africa: Evidence from the Markov Switching Vector Autoregressive Model

ABSTRACT

This paper introduces the possibility of asymmetry in the reaction of output growth to inflation shocks in South Africa by making use of the Markov-switching vector autoregressive model. Using quarterly data from 1969Q1 to 2013Q4, the empirical finding suggests that the reaction of output growth to inflation shocks is not only regime dependent but is also contingent on how the monetary authority reacts to such shocks. Two important regimes are identified; the high and low inflation volatility regimes. Consistent with the signal extraction theory, the output effect of inflation shocks is found to be significantly lower in the high inflation volatility regime compared to the low inflation regime.

KEYWORDS:

• Inflation
• economic growth
• non-linearity
• MSVAR

JEL CLASSIFICATION:

• C23
• E31
• O40

Notes

1. The studies have focused on Phillips curve models in assessing the relationship between inflation and output in South Africa.

2. The chosen order allows monetary policy to react to inflation shocks and the magnitude of this reaction depends on uncertainty (inflation uncertainty for the case of this paper) as predicted by the signal extraction theory.

3. Although the order is still consistent with signal extraction, we allow a lag response of GDP growth to different shocks.