The monetary model of exchange rate behaviour: the case of South Africa.

Abstract

The exchange rates behaviour has been a topic of interest in the macroeconomics literature. Despite the extensive body of the literature on the subject, the exchange rates movement remains controversial. In the previous 40 years, economists developed theories that intended to explain the behaviour of the floating exchange rates. However, the empirical results have not been consistent with the predictions of the theories. South Africa has also had challenges with its exchange rate behaviour since the beginning of World War I. Over the years, the monetary authorities tried various methods of managing the factors believed to influence the behaviour of the domestic exchange rates. The main problem of the domestic exchange rates has been constant depreciation. The domestic exchange rates continue to depreciate even to this day despite the efforts. This study focuses on the relationship of some monetary variables that are believed have effect on the behaviour of the exchange rates. The economic theory supports the link between monetary variables and the exchange rates behaviour. However, the relationship between domestic exchange rates fundamentals seems to diverge from what is expected. As noted, the literature fails to link the exchange rates with its fundamentals. In this study we use non-linear estimations to model the interaction between the macroeconomic fundamentals and the domestic exchange rates which are Markov Switching model, Bayesian VAR and Threshold Autoregressive model. Firstly, the study found that private information which is not observed might have more effect on the exchange rates behaviour than expectations of exchange rates. Secondly, we found that expectations of income have an impact on the domestic exchange rates in some occasions. While in other situations, the domestic exchange rates behaviour cannot be linked with the fundamentals. Lastly, the domestic exchange rates behaviour responds to interest rates differential, domestic debt and political uncertainty when the exchange rate fluctuation is relatively stable. When the domestic exchange rates are appreciating, only the interest rate differential can explain the domestic exchange rates behaviour. Furthermore, the domestic exchange rates response is asymmetric to effects of expectations.