The dynamic response of the rand real exchange rate to fundamental shocks

Abstract

PURPOSE : The authors analyse the relationship between the South African real exchange rate and economic fundamentals – demand, supply and nominal shocks. The paper aims to discuss these issues. DESIGN / METHODOLOGY / APPROCH :The authors use a time-varying parameter VAR to study the coherence, conditional volatility and impulse responses of the exchange rate over specific periods and policy regimes. The model is identified using sign-restrictions that allow for some neutrality of impulse responses over contemporaneous and long horizons. FINDINGS : The results suggest that the importance of fundamental shocks on the exchange rate is time dependent. Hence there is a loss in information when using standard linear models that average out effects over time. The response of the exchange rate to demand and supply shocks have weakened over the 1994-2010 period. RESAERCH LIMITATIONS / IMPLICATIONS : The period following financial crisis has strengthened the relationship between supply and demand shocks to the exchange rate, but has weakened the relationship between interest rate shocks and the exchange rate response. PRACTICAL IMPLICATIONS : This paper provides deeper insight as to how the exchange rate responds to fundamental shocks. This should help monetary policy understand the consequences of interest rate decisions on the exchange rate and the indirect effect of inflation on the exchange rate. ORIGINALITY / VALUE : This application is new to the South African literature. The authors propose that the use of interest rates is limited in affecting the value of the rand exchange rate over particular periods. Isolating fundamental shocks to exchange rates over time helps policy makers make clearer and more informed decisions.