Navigating Optimal Inflation Targeting in South Africa: A Regime-Switching DSGE Approach
Working paper 936
DOI:
https://doi.org/10.71587/v0fhcq05Keywords:
Inflation Targeting, Regime-Switching DSGE, Commodity Price Volatility, Monetary Policy, Optimal Policy, Bayesian Estimation, External Shocks, Interest Rate Smoothing, Small Open EconomyAbstract
South Africa’s mineral-driven economy requires adaptive inflation targeting to manage global commodity price volatility. Global commodity price swings challenge the South African Reserve Bank’s (SARB) 4.5% inflation target, adopted in 2000. This paper develops a regime-switching DSGE model to determine the optimal inflation target for South Africa, incorporating heteroskedastic commodity shocks and a regime-dependent Taylor rule. The target varies with policy preferences: output focus raises it, inflation focus lowers it. Optimized policy outperforms historical policy, enhancing inflation control through balanced stabilization, but foreign shocks remain challenging. Excessive interest rate smoothing weakens stabilization, limiting responsiveness. A dynamic targeting approach is essential to enhance resilience against external shocks, offering SARB a framework to adapt policy to South Africa’s commodity-driven conditions.
