Monetary policy in Israel and other developed countries is forward looking. The central banks in these countries are thus required to assess the effect of monetary policy (shocks) and accurately forecast the evolution of the economy for monetary decision-making purposes. Central bank monetary policy makers are guided by many models, ranging from purely statistical to theoretical models. This paper describes a basic structural VAR system for the Israeli economy, analyzes its characteristics and evaluates its forecasting performance.
In addition to the variables that usually appear in such models--activity, the exchange rate, the central bank interest rate and inflation--the model presented in this paper incorporates inflation expectations derived from the capital market, and it was found that this improves the model. It was further found that the exogenous variables included in the model contribute considerably to the explanation of the development of the endogenous variables in the past, and thus also enhance the ability to forecast them. The model shows that the central bank reacts more strongly to a shock in inflation expectations than it does to a shock in actual inflation. This result is consistent with monetary policy being forward looking.

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