Financial stability and monetary policy in South Africa.

Abstract

This thesis is presented in three distinct but related essays. The first essay (Chapter four) explores how financial stress interacts with monetary policy. Financial stress was measured using a time-varying financial conditions index constructed by Kabundi and Mbelu (2017) for South Africa employing thirty-nine monthly financial market variables and macroeconomic variables. The study employed a Markov Switching Vector Autoregression (MSVAR) model estimated with Bayesian methods to investigate this dynamic relationship. The findings reveal that interest rates respond negatively to a high financial stress shock, leading to an increase in credit growth. Despite the expansion of credit, real GDP growth increases marginally and then gradually declines. Given the complementary objectives of financial stability and monetary policy, it is concluded that monetary policymakers need to consider financial stability. Furthermore, the impact of monetary policy is not restricted to adjustments in interest rates; it affects other factors such as lending risk functions. The second essay (Chapter five) examines the interaction of housing-related macro-prudential policies and monetary policy. The study uses housing cycles in a Dynamic Stochastic General Equilibrium (DSGE) model with a small, open economy framework. We estimate the model with Bayesian techniques using South African data covering the period 2000Q1 to 2018Q4. The results indicate that monetary policy has negligible effects on house prices. We consider a loan-to-value (LTV) tool for macro-prudential policy. The results show that a one per cent rise in the LTV ratio, a tight macro-prudential policy, leads to increasing house prices, with significant effects on Consumer Price Index (CPI) inflation. The effects on CPI inflation suggest that monetary policy is not very effective. Efficient policy frontier analysis indicates that the introduction of macro-prudential policy yields an improved, effective outcome that lowers output and inflation volatility. The findings suggest that there is a need for coordination of monetary policy and macro-prudential policy. The third essay (Chapter six) investigates monetary policy and the role of countercyclical bank capital regulation in fostering macroeconomic and financial stability. We employ a DSGE model with a borrowing cost channel and endogenous financial frictions driven by bank losses, bank capital costs and credit risk. The study finds that a policy regime that combines an optimal Taylor rule and macro-prudential policies shows a clear trade-off between price and macroeconomic stability. The results emphasise the significance of the Basel III Accord in mitigating the output-inflation variability faced by the policy authorities, and questions the simultaneous deployment of an optimal Taylor rule.