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Dynamic Relationship Between Oil Price And Inflation In South Africa

Mehmet Balcilar, Josine Uwilingiye and Rangan Gupta

Journal of Developing Areas, 2018, vol. 52, issue 2, 73-93

Abstract: The oil price-inflation relationship has been at the center of attention among economists and policy analysts, especially after 1970's oil shocks that resulted in a significant increase in the rate of inflation in number of countries around the world. However in the recent years, a number of empirical study, mostly in developed economies, has found that the effect of oil price shocks on inflation has weakened; mainly due to a reduction in oil intensity in production process and lower inflation environment. Moreover, some empirical evidences have shown the response of inflation from a negative and a positive oil shock to differ. This study aims to investigate the evolving relationship between oil price and inflation in South Africa, using time series data of inflation and oil price starting from January, 1922 to July, 2013. The study has a policy relevance on monetary policy reaction to oil shocks as South Africa is a small open economy with higher dependency on oil import and a floating exchange rate system. We fit both symmetric and asymmetric dynamic conditional correlation GARCH (DCC-GARCH) to the data. The results reveal the oil price to have a positive relationship with inflation, however the correlation is low and ranges between 0.07-0.08. The time-series patterns show a tendency of temporary upward shift in the pair-wise conditional correlations during predominant oil crisis. We also observe an upward shift in correlation in the year 1986, which can be attributed to South Africa's oil embargo. Further, the asymmetric-DCC model, based on the DCC exponential GARCH (DCC-EGARCH) framework, which fits the data better than the symmetric DCC-GARCH, show that the positive shocks have higher effect on inflation than negative shocks of the same magnitude. Finally, we observe that the correlation has been decreasing gradually over time for both symmetric and asymmetric specification of DCC model. The weaker oil price-inflation relationship, observed in recent years, could be attributed to the South African Reserve Bank's commitment to stabilize inflation expectation in the presence of external shocks. The study highlights the relative importance of oil shocks on inflation, and recommends that the Reserve Bank needs to remain attentive to oil price shocks, especially the positive ones.

Keywords: Oil prices; inflation; causality; DCC-EGARCH (search for similar items in EconPapers)
JEL-codes: C32 E31 E52 (search for similar items in EconPapers)
Date: 2018
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Working Paper: Dynamic Relationship between Oil Price and Inflation in South Africa (2014)
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Handle: RePEc:jda:journl:vol.52:year:2018:issue2:pp:73-93