STRUCTURAL CHANGE AND NONLINEARITIES IN A PHILLIPS CURVE MODEL FOR SOUTH AFRICA

I. INTRODUCTION A crucial precondition for a central bank to maintain price stability is a stable and predictable trade-off between inflation and real economic activity. As Mankiw (2001) succinctly put it: "The tradeoff is inexorable because it is impossible to make sense of the business cycle, and in particular the short-run effects of monetary policy, unless we admit the existence of a tradeoff between inflation and unemployment" (pp. 45-46). The relevance of the Phillips curve for monetary policy came under close scrutiny during the 1970s, following its empirical failure in the face of supply shocks and changing expectations. Unexpected supply shocks, the Lucas critique (1976), labor market reforms, regime changes and imprecise measures of potential output, and the nonaccelerating inflation rate of unemployment (NAIRU) are various factors that make it unlikely that the Phillips curve will ever provide a tight fit for forecasting and policy analysis (Mankiw 2001). Despite these modeling difficulties, empirical evidence for developed countries shows that the Phillips curve model augmented to include supply shocks, expectations, and a time-varying NAIRU remains useful to examine the short-run effects of monetary policy (Cunado and de Gracia 2003; Debelle and Laxton 1997; Gordon 1997; Gruen et al. 1999; Hassler and Neugart 2003; Rudebusch and Svensson 2002; Stock and Watson 1999). The adoption of inflation targeting strategies by many advanced economies, emerging markets, and transition economies since the 1990s, reflects the importance of the Phillips curve in modern-day monetary policy. The main transmission mechanism that underlies an inflation targeting strategy is based on a direct link between monetary policy, aggregate demand, and inflation (Svensson 1999, 2000; Rudebusch and Svensson 2002). In addition, almost all models used by policy makers worldwide include some version of the Phillips curve that serves as an essential mechanism to examine the short-run effects of monetary policy shocks (Gruen et al, 1999). In 2000, South Africa adopted an official monetary policy framework of inflation targeting. Based on the evidence of recent studies, however, there is some uncertainty about the relevance of the Phillips curve for policy purposes. Jonsson (2001) shows that a positive shock to real output exerts upward pressure on prices after about five quarters. The results in Nell (2004) suggest that although the origins of inflation have changed to structural forces since the mid-1980s, demand-pull inflation has played an important role in South Africa's historical inflationary process. Akinboade et al. (2002), on the other hand, claim that the monetary authorities in South Africa can do very little to stabilize prices around the level of its major trading partners, because the dominant sources of inflation are unit labor costs and exchange rate changes, which occur autonomously from the pressure of demand in the product market. (1) Similarly, Fedderke and Schaling (2005) advance the idea that inflation in South Africa is mainly a cost-push phenomenon. Aron et al. (2004) examine the various monetary transmission mechanisms in a four-equation macroeconomic system. The study shows that the output gap only affects consumer price inflation indirectly through producer price inflation. A direct channel is identified on the assumption that the current account ratio is a good proxy for demand pressure. The role of the conventional Phillips curve is further obscured by several complicated transmission mechanisms that appear to underlie the inflationary process. Finally, contrary to the theoretical prediction of the Phillips curve model, Hodge (2006, p. 175) finds a negative relationship between the level of the inflation rate and output growth. The main objective of this article is to reexamine the role of the Phillips curve model for monetary policy analysis in South Africa. Unlike previous studies, the analysis proceeds by augmenting the Phillips curve model for major structural changes in the balance-of-payments and labor market. …