Analysis of the interaction between the exchange rate, the interest rate,Inflation and GDP in

South Africa
outline/structure of the report.

1.1Background

In the foreign exchange market, which is comprises of banks, forex dealers, commercial firms,
central banks, investment management firms, hedge funds, retail forex traders, and investors,
provides a marketplace for the buying, selling, exchanging, and speculation of currencies and
also provides a means for currency conversion for international transactions. When anything is
traded, it has a price, just like any other market. A currency is purchased and sold on the foreign
exchange market, with the price expressed in another currency. An exchange rate is used to
indicate that price, However, this is more than simply a price. St is vital to the economy since it
has a direct impact on imports, exports, and cross-border investments. It influences other
economic variables indirectly, such as the domestic price level, Pd, and real wages (Anderson,
2020). According to the Triennial Central Bank Survey (2019) the forex market is the largest
market in the world surpassing even the stock market with a staggering $6.6 trillion daily
turnover.

The rate of exchange can be quoted either directly or indirectly. When the price of one unit of
foreign currency is represented in terms of the local currency, it is called a direct quote. When
the price of one unit of local currency is expressed in foreign currency, the quote is indirect. For
example, the exchange rate for the United States dollar (USD) to the South African Rand (ZAR)
as at 05 Apr 2020 was 19.293 ZAR, this is a direct quote and means that one USD costs 19.293
ZAR.

An exchange rate can either be fixed or a floating exchange rate. A fixed exchange rate is a
government or central bank policy that links a country's official currency exchange rate to the
rate of another currency or the price of gold. Between 1944 and the early 1970s, the South
African pound was fixed at a rate of US$ 4.03 according to the Bretton Woods Agreement of
1944.South Africa only adopted the floating exchange rate regime in February 2000 which lead
to the depreciation of the rand against the dollar (Hsing, 2016).

Some of the most important components that affect the exchange rate that we are going to be
looking at is Interest rates which can be defined as the cost of borrowing money which is stated
as an annual percentage rate (APR). It may also refer to a stockholder's share of a company's
market value, Inflation which measures how much more costly a collection of goods and services
has gotten over time, typically a year and GDP which according to Stat SA(2022) is the sum
value of all products and services produced inside a country's borders over a specified time
period, generally a year or quarter (SA, 2022).
Interest rates, inflation, and exchange rates are all linked. Central banks control both inflation
and exchange rates through controlling interest rates, and altering interest rates affects both
inflation and currency values. Higher interest rates provide a better return to lenders in a given
economy than in other countries. As a result, higher interest rates attract foreign money, driving
up the currency rate. Theoretically GDP and exchange rates have a positive relationship as,a high
GDP indicates higher production rates, which indicates more demand for the country's goods.
Higher demand for a country's goods and services frequently translates into increased demand
for its currency (Beers, 2020).

1.2 INTRODUCTION

In world economics, exchange rates play a pivotal role because they explain and study elements
that determine the real exchange rate and factors that influence its volatility. Arnold (2005)
defines an exchange rate as the price of one currency against another. Exchange rates play a
crucial role in international trade not only in setting prices but also in determining the type of
hedging to be applied to avoid exchange rate risk (Ramasamy and Abar, 2015). The purpose of
this study is to analyse the interaction between exchange rate, interest rate and other
macroeconomic variables like inflation and GDP in South Africa. Exchange rate and interest rate
have become an important topic of discussion in international finance as well as in developing
countries, with more and more economies adopting trade liberalization as a prerequisite for
economic growth (Obansa, Okoroafor, Aluko and Eze, 2013).

According to a study by Sanusi and Meyer (2018) rising domestic interest rates can lead to
higher exchange rates if interest rates exceed global interest rates. This is because if interest rates
exceed the global average interest rate, foreign investors will be more motivated and will put
pressure on the demand for domestic currencies (Sanusi and Meyer, 2018). The domestic stock
price will increase making domestic financial assets more attractive and as a result, individual
investors or firms will adjust their domestic and foreign portfolios by demanding more domestic
assets (Mehta and Varsha, 2011). This shows that inflation and stock prices are linked because
when there is a significant increase in price levels, the purchasing power declines, and the
domestic currency buys fewer goods and services (Mehta and Varsha, 2011).
2. Literature review: Explanation of theories linking the currency market, interest rates and the
selected macroeconomic/financial variables and a brief review of previous empirical studies
conducted on a similar topic.

2. Literature Review

2.1 Literature

According to the literature study, there is theoretical and empirical evidence for the interaction
between the exchange rate, interest rate, and other macroeconomic variables, allowing for
evaluating the link between the interaction of these factors. The relationship will be the subject
of our research, and related studies will be examined. Many researchers (e.g., Fama, 1981;
Hashemzadeh and Taylor, 1988; Abdullah and Hayworth, 1993; Darrat and Dickens, 1999) use
multivariate vector autoregressive models, Johansen cointegration, and the Granger causality
tests to investigate the relationship between currency market prices/returns and macroeconomic
variables in South Africa. Schwert (1989) studies the relationship between macroeconomic
variables (industrial production, short-term interest rates, long-term and intermediate-term bond
yields, money growth, and inflation) and stock market volatility. He contends that volatility is
not just persistent in stock market returns but that some macroeconomic indicators are more
volatile.

Some of the earlier research in this decade includes a paper by Qaisar Abbas,Javid Iqbal and
Ayaz that was published in 2012,where they analyze the Relationship Between GDP, Inflation
and Real Interest Rate with Exchange Rate Fluctuation of African Countries.This research
examined data from ten African nations spanning 15 years, from 1996 to 2010. In order to
explore their link that causes exchange rate swings, three independent variables were employed,
namely inflation, interest rate, and GDP. The data were analyzed using three hypotheses as a
foundation. According to the findings, GDP has a strong association with the exchange rate, but
interest and inflation have a non-significant relationship with African nations' exchange rates.
Keminsky and Schumulkler (1991) used daily data from Indonesia, Korea, Malaysia, the
Philippines, Thailand, and China to investigate the time series link between daily exchange rates
and interest rates. They discovered that the indications of these associations were highly volatile,
leading them to infer that interest rates in those nations could not be an exogenous variable.
Goldfajn and Baig (1991) used Vector Autoregression (VAR) based on the impulse response
function from daily interest rates and exchange rates to investigate the relationship between real
interest rate and real exchange rate for Asian nations from July 1991 to July 1991. They have not
come to any firm conclusions on the relationship between interest rates and currency exchange
rates.

2.2 Empirical Review

2.2.1 Interaction between exchange rate and inflation

Albuquerque and Portugal (2005) investigated the relationship between exchange rates and
inflation volatility. They used the bivariate GARCH model for testing and found that a
relationship between exchange rates and inflation variance existed. Berument (2002) also looked
at the effect of exchange rates on inflation and found that exchange rate affects inflation. In
addition, he tested the effects of the Consumer Price Index and the producer price index
separately (Burement, 2002). The results show that the producer price index is more sensitive to
exchange rates than the CPI (Burement, 2002).

2.2.2 Interaction between exchange rate and GDP

Fang-Yuan and Jun-Guo (2012) conducted an empirical study of the impact of GDP and
exchange rates on foreign exchange reserves using a quantile regression model of relevant data
from 1985 to 2010. Based on relevant data from 1985 to 2010, this study uses a quantile
regression model to conduct an empirical study of the impact of GDP and exchange rates on
foreign exchange reserves (Fang-Yuan and Jun-Guo, 2012). The result is that both GDP and the
exchange rate significantly affect the size of foreign exchange reserves, and the effect of
exchange rates on foreign exchange reserves is greater than the middle and low quintile GDP
(Fang-Yuan and Jun-Guo, 2012). Mahmood, Ehsanullah, and Habib (2011) analysed the impact
of the exchange rate on total macroeconomics using annual time series data from 1970 to 2009 in
Nigeria based on annual time series data for the period 1970 to 2009. The study examines the
direct and indirect relationship between the real exchange rate and GDP growth. The results
showed no solid direct relationship between exchange rate changes and GDP growth.

2.2.3 Interaction between exchange rate and interest rate

This nexus between interest rates and exchange rates is not only of interest to scholars but also to
policymakers. Central banks in developing economies tend to use interest rate and exchange rate
policies to curb inflation (Holtemöller and Mallick, 2016). Kim and Ratti (2006) provided
evidence using the simple linear expectation model that a sharp rise in interest rate could lead to
corporate bankruptcy and further deepen the currency crisis. From a more technical aspect, a one
standard deviation interest rate shock is associated with a statistically significant reaction in the
exchange rate (Kim and Ratti, 2006). Krušković’s (2017) study agrees with the above statement
and points out that in addition to the basic characteristics of the economy, the level of foreign
exchange reserves is also influenced by interest rates. Interest rates must be kept competitive to
prevent capital outflows and low enough to not negatively affect operating costs or generate
capital outflows and thereby deplete foreign reserves (Krušković, 2017).

3. Methodology: Description of the variables and data used (noting any transformations
performed), the sample period and the model to be employed (i.e. all the necessary estimated
equations). You should provide a clear explanation of all steps followed in estimating the results
and the hypothesis tests conducted at each step.

Establish both short- and long-run relationships between the exchange rate, interest rate and
other macroeconomic/financial variables in South Africa.

o conducting unit root tests

o cointegration techniques

o VAR

o VECM using the EViews software

o discuss your findings in relation to the literature and previous studies

• Data- Use the real effective exchange rate, one of the interest rates (short-term or
medium/long-term bond yield) and any other 2 macroeconomic or financial variables of your
choice (e.g. stock market index)

O Data frequency should be monthly or quarterly, depending on data availability of the selected
variables

oaccess the required data from the websites or databases of the following organisations,
accessible off campus:The South African Reserve Bank (SARB), Statistics South Africa (Stats
SA), INET BFA (McGregor), and Infront.Your data should be seasonally adjusted and in real
form (i.e. not nominal), where necessary. Thus, you may consider performing some data
transformations before conducting your estimations. Refer to the following link for seasonal
adjustment of data in EViews: http://www.eviews.com/help/helpintro.html#page/content/series-
Seasonal_Adjustment.html

3. METHODOLOGY AND DATA

To investigate the interaction between the exchange rate, the interest rate,Inflation and GDP the
research model will be explained using variables.The analysis will look at interest rates,
inflation, GDP and exchange rates as variables and try to find a relationship between them using
statistical methods.
3.1. Variables

This study contains one dependent variable and three independent variables.The dependent
variable is the exchange rate(ZAR/USD), the dependent variables are interest rate,inflation and
GDP.

3.2 The Model

Theoretical model: The model comprises four variables which depict the exchange rate as a
function of interest rates, inflation rate and GDP.

Er = F(i, Cp , MS )

Where Er is the quarterly exchange rate in South Africa which is a direct quote(ZAR/USD),i is
the quarterly interest rates,

3.3. Data

The data for the research was collected through secondary sources(trade economics,SARB,Stat
SA and statista), and the sample used in the research is for a period of 10 years which spans from
2012 to 2022 and contains 123 observations.In this paper exchange rates,inflation and interest
rate data was converted to quarterly data in order for it to be comparable to GDP data which is
released quarterly.

Variable Description Duration/Units Source

Exchange
Rate(ZAR/USD)

Interest Rate
 Inflation

GDP

Table 1: Description of data

3.3.1 Unit Root Tests

3.4 Statistical Tool

4. Results and discussion: Presentation and interpretation of the results (please avoid inserting all
EViews output in the write-up of your main report; present the results in concise tables and
report the relevant results only and you may then place the rest of the results/estimations in
appendices, appropriately labelled) and discussion of the results (explain your findings relative to
the expected relationship/s between the variables and indicate whether your results are
similar/different to those from other recent studies). Please present your results as is the
convention to do so (you can refer to other studies that conducted similar analyses).

4.Results and Discussion

4.1 Descriptive Analysis

4.2 Hypothesis Testing

4.2.1 The effects of Interest Rates on Exchange Rate

4.2.1 The effects of inflation on Exchange Rate

4.2.2 The effects of GDP on Exchange Rate

4.2.3The effects of GDP on Exchange Rate

5. Conclusion: Conclude your assignment and provide necessary recommendations based on

your findings. Remember to indicate the limitations of your analysis, if any.

5.Conclusion

Some of the limitation of this study include the number of dependent variables that were
included in the model, although the three variables that were selected are imperative when
studying the movement of exchange rate they are however insufficient and on future report we
recommend adding other variables that are suitable for the time period under study and also take
note of the simultaneity of the variables.we also recommend accounting for structural breaks in
data over different periods as this will enhance the research visibility and findings.We have
ultimately found that all the three selected variables and the exchange rate have a positive
relationship in the long run.
References:

Albuquerque, C.R. and Portugal, M.S. (2005). Exchange rate and inflation: a case of sulkiness of
volatility. UFRGS, Departamento de Economia, texto para discussão, (1).

Arnold, R.A. (2005). Macroeconomics. (7th ed). Mason; Thompson Western.

Berument, H., (2002). Döviz Kuru Hareketleri ve Enflasyon Dinamiği: Türkiye Örneği.

Deo, M., 2021. The Influence of Macroeconomic Variables on the Stock Market Performance.

Fang-Yuan, L. and Jun-Guo, S. (2013). The Empirical Research of the Impact of GDP and
Exchange Rate on Foreign Exchange Reserve Scale in China-Based on Quantile Regression
Model. Research journal of applied sciences, engineering, and technology, 5(6): pp.2113-2117.

Holtemöller, O. and Mallick, S. (2016). Global food prices and monetary policy in an emerging
market economy: The case of India. Journal of Asian Economics, 46: pp.56-70.

Kim, J.K. and Ratti, R.A. (2006). Economic activity, foreign exchange rate, and the interest rate
during the Asian crisis. Journal of Policy Modeling, 28(4): pp.387-402.

Krušković, B.D. (2017). Exchange rate and interest rate in the monetary policy reaction function.
Journal of Central Banking Theory and Practice, 6(1): pp.55-86.

Mahmood, I., Ehsanullah, M. and Habib, A. (2011). Exchange rate volatility & macroeconomic
variables in Pakistan. Business management dynamics, 1(2): p.11.

Mpofu, R. (2011). An Analysis of the South African FTSE/JSE All-Share Index and the
Macroeconomic Variables during the period 2002 to 2010. Corporate Ownership and Control,
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Obansa, S.A.J., Okoroafor, O.K.D., Aluko, O.O. and Eze, M. (2013). Perceived relationship
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journal of humanities and social sciences, 1(3): pp.116-124.
Ramasamy, R. and Abar, S.K. (2015). Influence of macroeconomic variables on exchange rates.
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Sanusi, K.A. and Meyer, D.F. (2018). An Econometric Analysis of the Relationship between
Changes in Government Bonds, Exchange Rate and Inflation Dynamics in South Africa. Journal
of Economics and Behavioral Studies, 10(4): pp.165-173.

Singh, T., Mehta, S. and Varsha, M.S. (2011). Macroeconomic factors and stock returns:
Evidence from Taiwan. Journal of economics and international finance, 3(4): pp.217-227.

Anderson, S., 2020. Foreign Exchange Risk.

Beers, B., 2020. What Indicators Are Used in Exchange Rate Forecasting?.

Hsing, Y., 2016. Determinants of the ZAR/USD exchange rate and policy implications: A
simultaneous-equation model.

SA, s., 2022. statssa. [Online]

[Accessed 20 4 2022].

Triennial, 2019. BIS Triennial Central Bank Survey.

PICKING OTHER RELEVANT VARIABLES(IDEAS!!)

1. An Econometric Analysis of the Relationship between Changes in Government Bonds,

Exchange Rate and Inflation Dynamics in South Africa
2. Money supply and Employment
3. What Are Key Macroeconomic Variables?(Interesting article:) )
a. Impact of Interest Rate, Inflation and Money Supply on Exchange Rate Volatility
in Pakistan

Please insert your sources here!!

Sources: