This paper offers a methodology to decomposing the changes in the ILS/USD exchange rate into a global-exogenous component and a local-residual one. This decomposition is of interest to monetary policymakers, exchange rate policymakers, and for financial stability.
The decomposition methodology, which is appropriate for exchange rates of small open economies versus the US dollar, is implemented in this paper on the mean and the variance of the quarterly changes of the ILS/USD, on the Uncovered Interest rate Parity (UIP) and Purchasing Power Parity (PPP), and on Dornbush (1976) overshooting model. Each of these parities/models is examined with and without the global component and its significance is tested using several statistical methods (OLS, GARCH(1,1)-M, and Co-integration equations). It is found that during the sampled period, I/1993 - II/2009, the global component was positive and significant in all parities/models and contributed 20 to 30 percent of the changes in ILS/USD exchange rate changes. This significant and persistent result points on the importance of including a global component in FX models and parities of small open economies. The fact that a global component is omitted in the current FX parities and models may partially explain their relatively low significant level as they do not consider the behavior of the US dollar against the global currencies

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