n Studies in Economics and Econometrics - Structural changes and models of inflation in South Africa

Abstract

In the past three decades South Africa has undergone a number of structural changes in the economy, which may have contributed to parameter instability in inflation equations. In this study the out-of-sample forecasting performance of three single equation models for inflation in South Africa is examined without imposing the restriction that coefficients are fixed over time. A time-varying parameter regression (VPR) technique based on the recursive application of the Kalman filter is used to evaluate the stability of the models using South African quarterly data from 1971.1 to 1998.3, with 1998.4 to 2001.3 excluded from the estimated sample period in order to do an ex post forecast evaluation. It is found that the parameters of the expectations-augmented Phillips curve and the traditional monetarist models for inflation are fairly stable over the sample period, whereas the money demand model for inflation shows signs of changing parameters over time. This is in accordance with some changes in monetary policy during the 1980s and a degree of financial liberalisation since 1994. It is furthermore shown that, under conditions of structural instability, the VPR money demand model can substantially reduce out-of-sample forecasting errors compared to its fixed-coefficient counterparts.