This study examines the impact of exchange rate volatility and misalignment on economic growth in South Africa. It applies the Johansen co integration test and the vector error correction model on quarterly data for the period 1990:01-2010:04. Exchange rate volatility is measured as the standard deviation of both the nominal and nominal effective exchange rate. The study constructs three measures of exchange rate misalignment, with two of the measures constructed using the Producer Price Index and Consumer Price index based Purchasing Power Parity. The third measure was based on the difference between the nominal and effective exchange rate. Contrary to pre-dominant findings in the exchange rate literature, the study finds a positive and significant relationship between exchange rate volatility and economic growth and attributes it to composition of the country’s exports that are largely made up of commodities that act as essential inputs in many production processes. As a result, the variability of prices caused by exchange rate volatility is not expected to deter demand for these commodities. A negative and significant relationship between exchange rate misalignment and economic growth was found. The findings of the study show that it is important for monetary authorities to ensure that the exchange rate is always at an appropriate level in order to avoid the negative implications of exchange rate misalignment on economic growth.

MCOM / Department of Economics / The choice of a weak or strong currency has been at the center of the debate in most developing economies as exchange rates play a vital role in a country’s level of economic growth. This growth is critical to many developing economies. The study assessed the role of real exchange rate on economic growth in South Africa from 1994, first quarter, to 2015, fourth quarter. The study used time-series data in which Augmented Dicky Fuller and Philip Perron tests for stationarity, cointegration test, Vector Error Correction Model (VECM) approach for the long-run relationship were conducted. Impulse Response Function (IRF) and Variance Decomposition (VD) were also conducted to explain the response to shock amongst variables and how much of the forecasting error variance is explained by the exogenous shocks to other variables. VECM results showed a positive role exchange rates play on economic growth in South Africa. The study’s implication is that currency devaluation (exchange rates depreciation) can be effective in improving economic growth in the short-run. Nonetheless, a strong currency is good for economic growth in the long-run as it attracts foreign investments and a good instrument for controlling inflation. Thus, basing on the findings of the study, the floating exchange rate system adopted by South Africa in 2000 can be maintained.