The impact of financial development on the effectiveness of monetary policy in South Africa

The study examines how financial development affects the effectiveness of monetary policy in influencing output and inflation in South Africa, through its interaction with the repo rate. Monetary policy effectiveness in this relationship is measured by the responsiveness of output and inflation to an interaction-term between a financial development indicator and the repo rate.This is carried out by estimating an output and inflation equations incorporating the interaction-term as an explanatory variable in each of theoutput and inflation equations. If the coefficient of the interaction-terms is negative and significant it implies that the effectiveness of monetary policy in influencing output and inflation is enhanced. On the other hand, a positive and significant coefficient of the interaction-terms means that the interaction of the financial development with the repo rate dampens monetary policy effectiveness in influencing output and inflation. Considering the adoption of an Inflation Targeting Framework (ITF) monetary policy framework in 2000, the study further examines how the regime shift has affected the effectiveness of monetary policy in South Africa. The study employs an Autoregressive Distributed Lag (ARDL) model to analyse the data for long-run co integration and an Error Correction Model (ECM) to test for a short-run relationship. Additionally, the study uses a structural VAR to assess how long it takes for the interaction-terms to have full impact on output and inflation. The study concludes that the effect of monetary policy on output and inflation is enhanced through the interaction of the bank-based financial development indicator with the repo rate in South Africa. It also concludes that it takes about three quarters and four quarters for the bank-based interaction-term to have full impact on output and inflation respectively, which is quicker than it takes for the repo rate individually to have full impact on these variables. The study also finds that after the adoption of the ITF, the repo rate managed to restrain inflation to be within the targeted band at the expense of output. The study recommends that the South African Reserve Rank (SARB) should consider the bank-based financial development indicator when formulating its monetary policy.