Forecasting South African Macroeconomic Variables with a Markov-Switching Small Open-Economy Dynamic Stochastic General Equilibrium Model

Abstract

The aim of this paper is to investigate structural changes in the South African economy using an estimated small open-economy dynamic stochastic general equilibrium(DSGE) model. The structure of the model follows recent work in this area and incorporates the expectations of agents and a number of shocks that are assumed to affect the economy at various points in time. In addition, the dynamic linkages between the respective variables in the model may be explained in terms of the micro foundations that characterize the behavior of firms, households and the central bank. After estimating the model, we allow for the parameters in a number of different structural equations to change periodically over time. Different versions of the model are assessed using various statistical criteria to identify the model that is able to explain the changing dynamics in the South African economy. The results suggest that the central bank has responded in a consistent manner over the sample period; however, there are periods of time where it does not focus too greatly on output pressure. This impacts on some of the impulse response functions where we note that a monetary policy shock has a slightly larger effect on inflation, while the risk-premium shock has a larger effect on output, inflation and interest rates.