The effects of fiscal policy on the current account and real exchange rate in South Africa.

Abstract

This dissertation empirically studies the effects of expansionary fiscal policy on the current account and the real exchange rate in the South African economy. Recursive vector auto-regressive models based on the Choleski factorization identification scheme are used in the empirical analysis. This identification approach requires the imposition of restrictions on the VAR model and the most endogenous variables are ordered last. The dissertation uses quarterly data for the period 1990:1 to 2014:4 which was collected from the South African Reserve Bank website and the World Development Indicators. A 5-variable reduced form VAR model is used to generate various impulse response functions (which show the response of other variables to a shock to one variable), to carry out a variance decomposition (to assess how much variation in one variable is caused by another variable’s error term) and to conduct Granger causality tests (to assess whether each variable Granger causes, or is caused by, each other variable). The variables examined are: the government budget deficit (GOV), the current account (CUR) (both measured as percentage of GDP), the logged real exchange rate (LREER), logged real GDP (LRGDP) and the 3–month real interest rate (RIR). The current literature is quite inconclusive about the relationships between the government budget deficit, the current account and the real exchange rate and is generally focused on developed countries, in particular the United States. This dissertation contributes to the literature from a South African perspective. In spite of concerns about “twin deficits” (that is, when the fiscal deficit increases, the current account deficit worsens) for the South African economy, empirical evidence indicates that “twin divergence” is a more usual feature of historical data. In contrast to most of the theoretical models, the results for the South African economy suggest that an expansionary fiscal policy shocks improves the current account, depicting “twin divergence”. The effects of fiscal deficits on the real exchange rate seem to be consistent with the conventional view, that a government budget deficit induces a real exchange rate appreciation. The “twin divergence” of fiscal policy and the current account is also explained by the greater prevalence of output shocks than fiscal shocks.