The Effects of Expectation Inflation on Aggregate Demand: Examining the South African Inflation Expectation Channel of South African Monetary Policy

Abstract

South Africa targeted inflation since February 2000 as its monetary policy framework to ensure long-run price stability and continues to pursue a target of 3-6% for headline CPI inflation. Monetary policy emphasises the importance of promoting economic growth that can be sustained and maintenance of low inflation in an economy. Therefore, the paper seeks to check whether a relationship between economic growth (GDP) and expectation inflation exists. The autoregressive distributive lag (ARDL) econometric methodology was employed to achieve the objectives. The ARDL bounds test found that there is a long-run cointegration between GDP and expectation inflation. Moreover, the ARDL results revealed that in the long run expected inflation had a negative significant effect on GDP. This implies that lower expectation inflation could stimulate economic growth. It is recommended that South Africa should continue to target inflation because its target band of 3% to 6% keep policy makers on the loop.

The Impact of Inflation Expectations and Public Debt on Taxation in South Africa

“…This is in line with economic theory, and the fiscal theory of price level because when consumers, as well as businesses, expect the inflation rate to rise in the future, this will increase their income tax, capital gains tax, and profits [14]. However, these findings differ from some studies that found a negative relationship though that study was between inflation expectation and aggregate demand [18].…”

“…Although a considerable amount of research has been conducted on the issues of public debt and expected inflation, there is a research gap on the impact of inflation expectations and public debt on taxation especially in South Africa [17][18][19]. For instance, there is a South African study that employed the Autoregressive Distributive Lag (ARDL) to evaluate the nexus between inflation expectations and aggregated demand using secondary time series data [18]. The study revealed that when employing the Error Correction Model (ECM), a 1% increase in inflation expectations would lead to a 0.4% decrease in the level of gross domestic product, ceteris paribus.…”

“…The study revealed that when employing the Error Correction Model (ECM), a 1% increase in inflation expectations would lead to a 0.4% decrease in the level of gross domestic product, ceteris paribus. Since a shadow economy cannot be taxed, it destroys the tax base and reduces the tax revenues, forcing governments to resort to other ways to finance their expenditure [18]. In supporting this statement, another study measured the impact of the shadow economy on inflation and taxation using panel data of 162 countries from 1999 to 2007 [19].…”

“…An ARDL-based ECM is employed in this study to analyze the short-run effects of inflation expectations and public debt on taxation. After testing for stationarity, if variables portray different orders of integration like at first level [I (0)] or at first differencing [I (1)], the ARDL can be employed [18,32,33]. The ARDL approach simultaneously captures the cointegration between a set of variables, the long-run and short-run estimates including the speed of adjustment.…”

“…The short-run relationship in the model is represented by β 1 À β 4 coefficients, phi denotes the speed of adjustments, and ECM denotes the residual obtained from estimated cointegration in the equation. As Engle and Granger in 1987 put it, error-correcting or simply ECM allows long-run components of variables to obey equilibrium constraints while short-run components have a flexible dynamic specification [9,18,21]. After confirming the long-run equilibrium among the variables with the bounds test, the short-run, long-run and ECM coefficients (α, β's, δ, φ) are estimated using ARDL [21].…”