We formulate and estimate a New-Keynesian model for a small open economy. The moel consists of three structural equations: for inflation, the output gap and the exchange rate - and is closed with an interest-rate reaction function. Our goal is to construct a realistic model that can be used to forecast the future path of the relevant variables, including the interest-rate path that is needed to achieve the inflation target. In addition the model can be used for evaluating the effect of different policies and exogenous shocks on the relevant variables. For this end, we tried to satisfy economic theory while achieving good empirical dynamics among the relevant variables. The model parameters were estimated using Israel quarterly data between 1992 - 2004.

The results confirm the view that in a small open economy the exchange rate has an important role in the monetary transmission mechanism. Changes in the interest rate affect the exchange rate, which is one of the determinants of inflation and the output gap. In addition we find that the pass-through from the exchange rate to the local prices is gradual rather than immediate, although complete. In line with other economies, we also find inertia in the inflation and output gap processes. Following various shocks hitting the economy, inflation returns to equilibrium within three to five quarters, and the output gap within eight quarters.

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