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Licensed Unlicensed Requires Authentication Published by De Gruyter September 25, 2015

The Determinants of Long-run Real Exchange Rate in South Africa: A Fundamental Equilibrium Approach

  • Bernard Njindan Iyke EMAIL logo and Nicholas M. Odhiambo
From the journal Global Economy Journal


In this paper, we identify the fundamental determinants of the long-run exchange rate in South Africa. We then estimate the equilibrium real exchange rate for this country using a dataset covering the period 1975–2012. In order to account for possible short-run fluctuations in the real exchange rate, we conducted a cointegration test using the ARDL bounds testing procedure. First, we found terms of trade, trade openness, government consumption, net foreign assets and real commodity prices to be the long-run determinants of the real exchange rate in South Africa. Second, we found that nearly 68.06% of the real exchange-rate disequilibrium is corrected annually. Overall, the estimated equilibrium rate indicates that the Rand has been depreciating in real terms over the years. Tightening trade openness is not an option, given international agreements; on the other hand, terms of trade and real commodity prices are determined by the world market. The obvious policy alternative is for South Africa to increase government spending and moderately decrease her net foreign asset position.

JEL Classification: C53; F31


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Figure 6: The Fundamental Determinants of Real Effective Exchange Rate in South Africa (1975–2013).
Figure 6:

The Fundamental Determinants of Real Effective Exchange Rate in South Africa (1975–2013).

APPENDIX B Some Notes on the Hodrick-Prescott Filter

The Hodrick-Prescott (HP) filter or decomposition is a technique employed in macroeconomics and macroeconometrics to decompose a time series into cyclical and trend components. The technique was proposed by Whittaker (1923). But it was not until the seminal paper of Hodrick and Prescott (1997), when the HP-filter gained immense recognition. The main importance of the HP-filter lies in its ability to provide a smooth-curve representation of a time series which is susceptible to long-run impacts than cyclical fluctuations.

The HP-filter is derived on the basis that a time series, say xt, could be decomposed into a trend (τt) and cyclical component (ct). Assuming, from this intuition, that xt=τt+ct+μt, where μt is the error term of the time series at period t. Then, there exist a positive value of a multiplier λ, such that τ solves the minimization problem:


According to Hodrick and Prescott (1997), the sum of the squared deviations dt=xtτt penalizes the short-run fluctuations in the time series. The second term is a multiple of the multiplier (λ) and the sum of squares of the second differences in the trend component of the series. This term penalizes deviations in the growth of the trend component of the time series. Higher values of λ entail higher penalties. For quarterly data, Hodrick and Prescott (1997) suggest that λ = 1600 should be chosen. Ravn and Uhlig (2002) proposed we choose λ=6.25 and 129,600 for annual and monthly data, respectively.

Published Online: 2015-9-25
Published in Print: 2015-9-1

©2015 by De Gruyter

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