Growth in money supply has in most cases been referred to as the cause of inflation and it is also regarded as a leading indicator for inflation. According to Svensson (2000),
albeit high correlation between money growth and inflation in the long run, there is little
or no empirical evidence that identifies growth in money supply as a leading indicator for inflation.
Money supply is identified as one of the determinants of inflation particularly by the proponents of the monetary targeting system. Stals (1999) pointed out that monetary targeting contributed significantly to a reduction in inflation from the double digit levels of between 12% and 20% from 1972 to 1992 to an average of below 10% from 1994 to 1999. Figure 2.5 shows the trends in the rate of inflation and money supply from 1980 to 2013.
Figure 2.5: Inflation and money supply (1980-2013)
0 4 8 12 16 20 24 28 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Inflation
Money supply growth (M3)
Pe rc en ta ge % Years
Source: SARB; Stats SA (2015)
As shown in Figure 2.5, South Africa also experienced a significant decline in money supply from 27.3% in 1988 to approximately 7.0% in 1993. Subsequently, inflation also declined from 12.8% and 15% from in 1988 and 1991 respectively, to 9.3% in 1993. It is evident that monetary policy in the early 1980s was inflationary. This is based on the
31
behavior of some of the most important monetary policy aggregates and also because growth in aggregate demand has implications on the general price level mainly due to its reliance on the growth in the supply of money. Given that, it is also evident that the acceleration in inflation during that period had not been accidental. Over the past years high rates of inflation was directly linked with the growth in money supply in South Africa, as growth in money supply prevails, inflation also followed a similar trend although it‟s characterised by time lags.
According to Casteleijn (2001), time lags tend to differ from country to country due to differences in economic and financial market structures. Growth in money supply was roughly 15.3% in 1982 and it continued to grow to 18.0% in 1984. This growth in money supply was later followed by an increase in the price level from 11.5% in 1984 to 18.7% in 1986. According to the trend, there was a two year lag period before inflation responded to changes in money supply growth. This is evidenced by the behavior of money supply and inflation during the period 1982 to 1990 (see Figure 2.5). As indicated by Mboweni (2000, p. 67), monetary policy initiatives take time to make an impact on inflation because of the long lags (approximately 18 to 24 months).
The linkage between money supply growth and inflation indicates the role of money as one of the determinants of inflation in South Africa. However, Stals (1999) outlined that the usefulness of money supply targets as an indicator and a measure to stabilize the rate of inflation was affected by extensive financial liberalisation in the early 1980s through an increase in financial market activities and capital flows that led towards a more open economy in 1994. The latter statement is an indication that the determinants of inflation changes in line with the structural changes in the economy and as such, they should be carefully monitored owing to the fact that they affect the stability in the relationship between various macro-economic variables and inflation.
According to van der Merwe (1997), the growing integration of global financial markets, liberalisation of capital markets in South Africa, the elimination of strict exchange
32
controls and financial deepening in the form of the extension of banking services was significantly changed by the relationship between money supply (particularly M3) and the demand for goods and services.
The ongoing effects of liberalisation and the elimination of sanctions during the early 1990s were associated with an increase in real interest rates and a decline in inflation. During that period, the SARB was still pursuing a monetary targeting system as its main policy instrument. However, monetary targets were abandoned in the early 1990s and this was due to the monetary authorities‟ view that the relationship between inflation and growth in money supply was becoming unstable and unpredictable (Van der Merwe, 1997). Mohr (2008) observed that changes in monetary aggregates cannot be attributed to the decline in inflation in the mid-1990s as there was no noticeable decline in the rate of monetary aggregates.
In 1993, inflation rates decreased steadily from 9.7% to approximately 8.6% in 1997, whilst growth in monetary aggregate continued to increase from 7.0% to 17.3% during the same period. The expectation was that an increase in monetary aggregates would translate into an increase in the general price level. However, the trend from 1993 to 1997 clearly indicates that growth in monetary aggregates could not be attributed to inflation and as such, raised concerns with regards to the effectiveness of monetary targets achieving the ultimate goal of price stability. According to van der Merwe (2004, p. 1) „the growth in money supply and bank credit extension in the 1990s was above the guidelines of the authorities for a considerable period. In these circumstances the public expected an increase in short-term interest rates. However, in analyzing the situation the authorities realized that the high growth in the monetary aggregates was mainly due to structural changes in the economy resulting to a large extent from the liberalization of the financial system.‟ This was seen as a signal to the monetary authorities that there was a need to introduce a new policy strategy that would align monetary policy conduct with new developments in the determinants of inflation.
33
De Wet (1994) suggested that access to international financial markets in 1994, remains one of the crucial structural aspect in the South African economy. As a result of structural changes in the economy due to liberalisation in the early 1990s, rapid growth in labour productivity suppressed an increase in nominal unit labour cost from 4.2% in 1992 to 12.8% in 1993 giving rise to steady real remuneration particularly to those people who received consistent work and payment (De Wet, 1994). Unlike most emerging market economies, South Africa has historically been an important player in international markets with a more open economy than many industrialised and developing countries.
Inflation declined to an average of 8.7% in 1995 compared to the 9.9% in the preceding year. From 1995, the inflation rate continued to decline up to 1999 albeit with a marginal increase of 1% between 1996 and 1997. However, it further declined significantly by 3.5% between 1997 and 1999 notwithstanding a sharp increase of 7.8% and 9.1% in the last two quarters of 1998.
The appreciation in the value of the Rand coupled with a corresponding hike in interest rates and the prospect of good rain for the season contributed to a reduction in food prices. This was identified as the one of the main reasons for a decline in the general price levels for the period 1995 to 1999. During that period, prime lending rates also increased from 17.9% to 21.8% in 1998. As indicated by Smal and de Jager (2001), the SARB‟s adoption of an eclectic monetary policy during the late 1990s was an indication that the inflation target did not necessarily have to be an officially announced target and this was the approach followed by the SARB as they indirectly pursued unannounced targets in order to achieve monetary policy goals.