Abstract
Our proposed semi-structural DSGE model for the Israeli economy, a small open economy, focuses on financial friction in the household sector credit market, capturing the positive relationship between households' leverage ratio and their interest rate (credit spread) on debt, as evident in Israeli data. This model aims to evaluate the implications of this friction on monetary and macroprudential policy.
Ignoring credit market developments can in our findings reduce monetary policy effectiveness in stabilizing inflation and real activity. Hence, monetary policy should consider credit spread dynamics. Macroprudential policy can increase the sensitivity of households' credit spread to their leverage, mitigating over-borrowing and reducing the risk of a debt deleveraging crisis. In scenarios of demand weakness and debt deleveraging, macroprudential policy can stimulate demand by reducing the credit spread alongside accommodative monetary policy.
JEL Classifications: E44, E52, G21, G51
Keywords: Monetary Policy, Household Leverage, Financial Friction, Macroprudential Policy.