An empirical analysis of real exchange rate and economic growth in South Africa

Abstract

The relationship between real exchange rate and economic growth has become an ongoing debate in economics and the rest of the world. The objective of this study was to investigate the relationship between real exchange rate and economic growth in South Africa. Using time series data, the period from 1980 to 2015 was considered in the study. The explanatory variables employed in the study were: gross domestic product deflator; money supply; export and foreign direct investment. Data was collected from the South African Reserve Bank, International Monetary Fund and International Financial Statistics. The Johansen cointegration and the Vector Error Co1Tection Model estimation techniques were used while Granger causality test was used to determine causality between the variables. Variance decomposition and impulse response function were subsequently performed to determine the response of real exchange rate to various shocks from the other variables used in this study. Results of the long-run revealed a negative and significant relationship between real exchange rate with expo1i and economic growth. On the other hand, money supply and foreign direct investment had a positive and significant relationship with real exchange rate. In the short-run, only export was significant and positively related to real exchange rate. Results of Granger causality revealed that only export Granger causes real exchange rate, thus an unidirectional causality exists between export and real exchange rate while other variables do not granger cause one another. Results of the variance decomposition revealed that real exchange rate is highly affected by shocks from economic growth while its response to export, money supply and foreign direct investment is so small. The impulse response functions revealed that real exchange rate responds positively to shocks from real exchange rate and money supply, while real exchange rate responds negatively to a shock from economic growth. Moreover, real exchange rate responds negatively than positively to shocks from foreign direct investment while the response of export is positive and later negative. There is, therefore, a need for government to maintain stable growth and focus on variables that affect real exchange rate positively. For example, encourage and maintain the level of foreign direct investment, a well balance of money supply and trade between imports and exports.