Search

We formulate and estimate a small New Keynesian model for the Israeli economy. Our goal is to construct a small but still realistic model that can be used to support the inflation targeting process. The model contains three structural equations: An open economy Phillips curve for CPI inflation (excluding the housing component), an aggregate demand curve for the output gap and an interest parity condition for the nominal exchange rate. The model is closed with an interest rate reaction function (Taylor-type rule) and an ad hoc equation for the housing component of the CPI, which is dominated by exchange rate changes. In the specification of the model we had to pay special attention to the crucial role of the exchange rate in the transmission of monetary policy in Israel, which has a direct effect on almost 60 percent of the CPI. The model is estimated by the GMM method, using quarterly data for the period 1992:I to 2005:IV. In the estimation of the structural equations we tried to remain as close as possible to the theoretical formulation by restricting the dynamics to one lag at most. We use the model to characterize an "optimal" simple interest rate rule. We find that the monetary authority should respond to an hybrid backward-forward looking rate of inflation and does not benefit from direct reaction to exchange rate measures.

This study presents a small New Keynesian model of Israel’s economy describing the relationships among the main variables relevant to the transmission mechanism of monetary policy. The model encompasses three structural equations––for inflation, the output gap, and the exchange rate––and an interest rate rule, that describes how the interest rate should be adjusted in order to eventually achieve the inflation target. The theory underlying the model is broadly in line with the current monetary theory prevailing in academia and central banks. The model is small, yet it includes the main channels through which the central bank’s interest rate affects inflation in a small open economy. An important advantage of a small model is its ability to describe, clearly and simply, the interrelation between the main variables that are related to the transmission mechanism of the monetary policy, while maintaining theoretical coherence. The model presented is intended to serve as an operational tool that can aid policy makers to assess the interest rate path required to achieve the inflation target, but it can also serve others interested in monitoring monetary developments or in forecasting the evolution of the relevant variables. The model can also help to focus the monetary-policy discussion and enhance the communication between the various entities, both within and outside the central bank, involved in monetary policy and its outcomes. To improve the forecasting ability of the model, in formulating the equations we tried to strike a balance between the need to maintain economic logic and the need to obtain an adequate empirical description of the relation between the relevant variables. The parameters of the model were estimated using quarterly data of Israel’s economy in the years 1992 to 2005.