A DSGE-VAR model for forecasting key South African macroeconomic variables

Abstract

The paper develops a Small Open Economy New Keynesian DSGE-VAR (SOENKDSGE-VAR) model of the South African economy, characterised by incomplete pass-through of exchange rate changes, external habit formation, partial indexation of domestic prices and wages to past inflation, and staggered price and wage setting. The model is estimated using Bayesian techniques on data from the period 1980Q1 to 2003Q2, and then used to forecast output, inflation and nominal short-term interest rate for one-to eight-quarters-ahead over an out-of sample horizon of 2003Q3 to 2010Q4. When the forecast performance of the SOENKDSGE-VAR model is compared with an independently estimated DSGE model, the classical VAR and six alternative BVAR models, we find that, barring the BVAR model based on the SSVS prior on both VAR coefficients and the error covariance, the SOENKDSGE-VAR model is found to perform competitively, if not, better than all the other VAR models.