Financial assets, linear and nonlinear policy rules

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Introduction

Theories of rules and discretion have become a corner stone in the formulation of monetary policy. Commonly, the Taylor (1993) rule model and its extensions (e.g.Clarida et al., 2000) are used. The rules assume that interest rates relate linearly to the gap between actual and desired values of inflation and output. The purpose of this study is to investigate how the South African Reserve Bank (SARB, hereafter) sets interest rates in the context of both linear and nonlinear policy reaction functions. Given the recent controversial debate on whether central banks should target asset prices for economic stability (see Bernanke and Gertler, 2001; Chadha et al., 2004 and Papademos, 2009), the study investigates whether the SARB pays close attention to asset prices and financial variables in their policy decisions. For instance, one of the SARB’s primary goals is to protect the value of the currency and achieve and maintain financial stability. But one of the questions the thesis aims to answer is “how has the SARB reacted to financial variables?” To answer to this question, the Taylor rule is augmented with a financial conditions index that reflects the state of the housing market, the stock market, the real exchange rate and credit risk measures.
In this thesis, the issue of linearity is tested. Indeed, a number of prominent authors have proved that central banks do not (or should not) behave linearly in setting the policy instrument (see Bec et al., 2002; Cukierman, 2002; Huang and Shen, 2002; Nobay and Peel, 2003; and Ruge-Murcia, 2003). Although the specification of a given model should be statistically and theoretically correct, it seems that researchers almost never give the reason they choose for most of the time linear specification. To avoid restrictions on possible nonlinear underlying economic behaviour, this study do not subjectively consider linear specification without any statistical support. As such, this research also intends to develop rival models having different specifications and so theselection of the best model will be based on empirical properties of the data.
It is well known that one of the prime benefits of robust economic models is the predictive accuracy they have. Furthermore, the Reserve Bank’s target for the repo rate is one of the most anticipated and influential decisions regularly affecting financial markets and is of interest to economic analysts, economic forecasters and policymakers. As such, this thesis assesses the out-of-sample predictive ability of the alternative monetary policy rules.

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Chap. 1: Introduction
1.1. Introduction .
1.2. Problem statement .
1.3. Aim and research objectives .
1.4. Importance of the research
1.5. Methodology .
1.6. Scope of study .
1.7. Limitations of study
1.8. Structure of the thesis
Chap. 2: Theoretical foundations and case study discussion 
2.1. Theoretical foundations: Monetary policy and rules
2.2. The South African monetary policy: contextual overview
2.3. Conclusion
Chap. 3: Research methodology 
3.1. Introduction .
3.2. The Hodrick-Prescott Filter .
3.3. Generalized Method of Moments (GMM) .
3.4. Conclusion .
Chap. 4: Data analysis and preliminary results
4.1. Introduction .
4.2. Data source and analysis
4.3. Preliminary results
4.4. Conclusion
Chap. 5: Financial assets, linear and nonlinear policy rules: an in-sample
assessment of the reaction function of the South African Reserve Bank
5.1. Introduction
5.2. Linear and nonlinear Taylor rule models
5.3. In-sample analysis
5.4. Conclusions
Chap. 6: The opportunistic approach to monetary policy and financial market
Chap. 7: Evaluating the forecasting performance of monetary policy rules in
South Africa
Chap. 8: Conclusions and implications 
References

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