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Global Economic Uncertainties and Exchange Rate Shocks pp 333–358Cite as

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Transitory and Permanent Components of the Exchange Rate Volatility

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Abstract

This chapter decomposes aggregate exchange rate volatility into permanent and transitory volatility components and determines their shock effects on the macroeconomy. What would have happened to the growth of gross value added by the manufacturing sector in the absence of elevated South African economic policy uncertainty changes to positive exchange rate volatility shocks? We find that an unexpected positive shock to aggregate and permanent exchange rate volatility depresses output for longer periods. But leads to a decline in inflation and repo rate consistent with the predictions of the Taylor rule and the Phillips curve. This evidence confirms that exchange rate volatilities and other policy uncertainties are indeed demand shocks and monetary policy has a role to mitigate the adverse effects. With respect to transitory exchange rate volatility shocks, we find that they are accompanied by unresponsive inflation and an insignificant decline in the repo rate. Aggregate exchange rate volatility explains more fluctuations in economic growth than permanent and transitory exchange rate volatilities. The contributions of aggregate and permanent exchange rate volatility components were a severe drag on economic growth, particularly during the recession in 2009. Therefore, the policy implication is that in the immediate aftermath of an exchange rate shock, it is critical to distinguish the relative contributions of the transitory and permanent components of shocks on the economic outlook. Counterfactual evidence shows that elevated South African economic policy uncertainty accentuated the decline in manufacturing sector gross value added following positive exchange rate volatility shocks.

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Notes

  1. 1.

    For instance, Dixit and Pindyck (1994) offered a theoretical case for the impact of high uncertainty on economic activity using the option value model, in which firms optimally adopt a wait-and-see approach when faced with high uncertainty, curtailing investment and hiring, and this retards economic growth.

  2. 2.

    Obstfeld and Rogoff (1998) argue that exchange rate volatility can affect households negatively through direct and indirect channels. The direct channel assumes that households and firms dislike exchange rate fluctuations and hence exchange rate volatility can have undesirable effects on their consumption and leisure decisions. Trade could fall in due to exchange rate uncertainty, and this could result in decline in production or income at home and foreign country and eventually aggregate consumption.

  3. 3.

    Grossmann and Orlov (2014) point out that the transitory (high) frequency component may be associated with short-term trading activity and often it changes with short periods.

  4. 4.

    The model diagnostics though not presented here indicate that the model is adequately estimated and the coefficients are statistically significant.

  5. 5.

    Grossman et al. (2014); Ganguly and Breuer (2010) conclude that interest rate changes have a stabilising effect on the residuals of volatilities of the nominal exchange rate, particularly in developing countries.

  6. 6.

    The FAVAR approach combines the standard VAR analysis with factor analysis. It is a quantitative attempt to condition VAR analyses of policy on richer information sets, without necessarily giving up the statistical advantages of restricting the analysis to a small number of variables. For further details, see for example, Stock and Watson (2002), Bernanke and Boivin (2003), Bernanke et al. (2004) amongst others.

  7. 7.

    They adjust their forecasts for inflation and economic outlook.

  8. 8.

    See IMF WEO January 2015.

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Authors and Affiliations

  1. Economic Research and Statistics Department, South African Reserve Bank, 370 Helen Joseph Street, Pretoria, South Africa

    Eliphas Ndou & Nombulelo Gumata

  2. Quantum Global Research Lab, Aegeristrasse 4, Zug, 6300, Switzerland

    Mthuli Ncube

  3. Wits Business School, University of the Witwatersrand, Johannesburg, South Africa

    Mthuli Ncube

  4. Said Business School, University of Oxford, Oxford, UK

    Mthuli Ncube

Authors
  1. Eliphas Ndou
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  2. Nombulelo Gumata
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  3. Mthuli Ncube
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Correspondence to Eliphas Ndou .

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Ndou, E., Gumata, N., Ncube, M. (2017). Transitory and Permanent Components of the Exchange Rate Volatility. In: Global Economic Uncertainties and Exchange Rate Shocks. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-62280-4_18

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  • DOI: https://doi.org/10.1007/978-3-319-62280-4_18

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  • Publisher Name: Palgrave Macmillan, Cham

  • Print ISBN: 978-3-319-62279-8

  • Online ISBN: 978-3-319-62280-4

  • eBook Packages: Economics and FinanceEconomics and Finance (R0)

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