Lecture by Mr TT Mboweni, Governor of the South African Reserve Bank, at the Department of Economics, University of Stellenbosch. Introduction Members of the Portfolio and Select Committees on Finance, Deputy vice-chancellor,Professors,Staff,Students,Ladies and gentlemen It is very pleasant to be on this side of the beautiful Hex River Mountains and to speak to you on a number of issues right at the core of central banking. The accusation is often heard that central bankers have narrowed the world down to inflation, and do not have an open mind on any other matters. Not true! The way in which these matters come together - the principles behind their interaction – will be central to my talk to you today. 2. The magnitude of the challenges facing our economy Starting with a longer-term picture of inflation, it is a well-known fact that the double-digit inflation which reigned from 1974 to 1992 left considerable scars on our economy. Its redistributive impact was nasty, with the buying power of the most vulnerable groups in society, the poor and the elderly, in particular being undermined. The plight of a pensioner who retired twenty years ago using interest on a fixed deposit to provide for himself or herself is illustrated by the cost of a basket of consumer items which cost R100 in early 1983. The cost of that basket shot up to R380 in early 1993, and currently amounts to R815. Although inflation has receded to single-digit levels and has averaged around 7,8 per cent per annum over the last ten years, this is still enough to very significantly erode the living standard of the most vulnerable groups in our society over time. Some distortions therefore remain, leading to frictions and misallocation of resources. High unemployment continues to characterise the South African labour market. Based on the responses of a representative sample of 30 000 households sampled in the February 2002 Labour Force Survey, Statistics South Africa puts the official unemployment rate at 29,4 per cent. The absolute number of the unemployed amounts to 4,7 million people. And these are people who are looking for jobs – it does not cover those who have given up. The opportunity cost to our economy is huge: even if each of them would only produce goods and services to the amount of R650 per month (the equivalent of the minimum wage in the lowest-paying areas), their combined output would amount to almost R40 billion per annum – almost as much as the value actually added in our entire agriculture, forestry and fishing sector. Disillusionment and desperation often accompany unemployment. Unemployment insurance – soon to be expanded to more sectors – can help to relieve some of the symptoms, but what is of course needed is the creation of a sufficient number of sustainable job opportunities to absorb the unemployed. To this end, most economists agree that sustained real GDP growth of around 5 to 6 per cent per annum is needed. Whereas South Africa barely managed to record an average growth rate of 1,5 per cent per annum during the 1980s, this has indeed accelerated to around 3 per cent per annum since 1994. Nevertheless, a significant and sustained further improvement is needed. The question is how? And in what way could monetary policy contribute towards such stronger growth? 3. Inflation and growth: is there a trade-off? Can more growth (and the other side of the coin, less unemployment) be bought by allowing more inflation? This question has interested economists a lot since 1958 when A W Phillips and R G Lipsey published their analysis of the relation between unemployment and the rate of change of money wages in the United Kingdom from 1861 to 1957. Empirical evidence indicated the existence of an inverse relationship between wage inflation and unemployment. This implied that an inflation-accommodating monetary and fiscal policy stance – an easy-money policy – could be used to reduce unemployment. However, this relationship turned out to be fragile at least and quite false at worst. Firstly, empirical evidence which accumulated in numerous count