Abstract
This paper presents a quarterly structural model of the Israeli economy which delineates the transmission mechanism of the monetary policy during the years 1989-1999 and allows to evaluate the short run consequences of various exogenous shocks on both the nominal and the
real sectors of the economy. The main endogenous variables of the model are the business sector output gap, the real exchange rate, the inflation rate, the Bank of Israel (BoI) short-term nominal interest rate and the rate of change of the business sector nominal wages. The estimated model is stable and exhibits to a large extent the expected properties in response to supply and demand shocks. The model specification and the estimation results give rise to a nominal transmission channel and a real activity transmission channel of the monetary policy to prices. Unlike large and relatively closed economies in which monetary policy affects prices through its effect on economic activity, in the case of Israel, the evolution of prices is affected first, through the nominal exchange rate channel, and only at a later stage is their effect felt on economic activity. The estimation results of the BoI nominal interest rate equation suggest a decreasing weight of short run economic activity in the interest rate evolution and a rising output and inflation volatility over time following supply side shocks.