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This chapter decomposes aggregate exchange rate volatility into permanent and transitory volatility components and determines their shock effects on the macroeconomy. What would have happened to the growth of gross value added by the manufacturing sector in the absence of elevated South African economic policy uncertainty changes to positive exchange rate volatility shocks? We find that an unexpected positive shock to aggregate and permanent exchange rate volatility depresses output for longer periods. But leads to a decline in inflation and repo rate consistent with the predictions of the Taylor rule and the Phillips curve. This evidence confirms that exchange rate volatilities and other policy uncertainties are indeed demand shocks and monetary policy has a role to mitigate the adverse effects. With respect to transitory exchange rate volatility shocks, we find that they are accompanied by unresponsive inflation and an insignificant decline in the repo rate. Aggregate exchange rate volatility explains more fluctuations in economic growth than permanent and transitory exchange rate volatilities. The contributions of aggregate and permanent exchange rate volatility components were a severe drag on economic growth, particularly during the recession in 2009. Therefore, the policy implication is that in the immediate aftermath of an exchange rate shock, it is critical to distinguish the relative contributions of the transitory and permanent components of shocks on the economic outlook. Counterfactual evidence shows that elevated South African economic policy uncertainty accentuated the decline in manufacturing sector gross value added following positive exchange rate volatility shocks.
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- Transitory and Permanent Components of the Exchange Rate Volatility
- Chapter 18
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